ACCOUNT BASICS

What is a defined contribution plan?

Understanding workplace retirement plans

A defined contribution plan is a common workplace retirement plan in which an employee contributes money and the employer typically makes a matching contribution. Two popular types of these plans are 401(k) and 403(b) plans. Defined contribution plans are the most widely used type of employer-sponsored benefit plans in the United States. The plan may require that you enroll yourself to take advantage.

Defined contribution plans and defined benefit plans have a number of notable differences. In a defined contribution plan, both you and your employer can contribute to your individual account. For some plans, you may be required to wait up to one year before enrolling. There may also be a waiting period before any contributions your employer makes to the account become yours to keep.

In a defined benefit plan, generally only your employer contributes and you get a monthly payout in retirement. There are two types of defined benefit plans: traditional pensions and cash-balance plans. Both plans automatically enroll participants. However, for some defined benefit plans, you must wait some period of time before you are enrolled and/or the benefits become yours to keep.

How do these workplace retirement plans work?

Employees invest in defined contribution plans to supplement their future Social Security benefits, as Social Security alone may not be enough to pay for retirement.

As an employee, you decide how much you want to contribute to your individual account. Your contributions are deducted from your paycheck and added to your account automatically. Many employers offer matching contributions. If you contribute a dollar, your employer may add a portion of a dollar in return, up to a certain percentage of your salary (usually 3-6%, though these percentages may vary).

Currently, the maximum amount an employee can contribute to a plan is $19,500 per year. If you are age 50 or older, you can add up to an additional $6,500, for a total of $26,000 per year (known as catch-up contributions). The IRS lists current contribution limits for various plans.

You can then choose how you want your money invested. Most plans offer several investment choices, and each has its own fee structure and risk profile.

You can start withdrawing funds from your account at age 59½. If you withdraw before then, generally you’ll face a 10% early withdrawal penalty. Many defined contribution plans also offer tax benefits. For example, in a 401(k) plan, your contributions are in pretax dollars; they grow tax-deferred until you withdraw the money.

What are the different types of workplace retirement plans?

While a 401(k) is the most common and popular type of defined contribution plan, there are other kinds as well — but not everybody can enroll in them. Some of the most familiar types include:

  • For employees of schools, health care entities and nonprofits.

  • For key government, educational and nonprofit employees. These money-purchase plans are structured so that the employer establishes custom eligibility requirements, contribution amounts and vesting schedules.

  • For public-sector employees, such as state and municipal workers, and employees of qualified nonprofits.

  • For federal employees. Because this plan includes very low costs, only a small amount of your retirement savings is diminished by fees and expenses.

     

  • For employees of businesses with 100 or fewer employees.

Considerations for investing in a workplace retirement plan

  • Consider making regular contributions to your individual account, up to the plan limit.
  • Determine whether you want to make your contributions on a pre-tax basis or after taxes using a Roth account.
  • Look into whether your employer provides matching contributions and consider taking advantage of your employer’s matching contribution to the fullest.
  • You’ll be given different choices regarding how your money will be invested. If you have any questions about which investment option might be best for you, consult a financial advisor.