What Are Defined Contribution Plans?
Defined Contribution Plans are retirement plans incorporate require regular contributions, equal to a percentage of the employee’s salary, in their design. They are the opposite of Defined Benefit Plans, which are employer-sponsored retirement plans. Based on their salary and retirement planning goals, employees decide contribution limits. Several iterations of these plans are available in the market and they include 401(k) plans, 403(b) plans, and SIMPLE IRAs. Required minimum distributions after the age of 72 are mandatory for some IRAs in order to maintain their tax-free status.
The advantage of defined contribution plans is that they are cheaper as compared to defined benefit plans. They also offer more tax benefits and have provisions for hardship withdrawals, meaning an account holder can withdraw funds from their defined contribution plan before time, if he or she faces a hardship.
The disadvantage of defined contribution plans is that the final payout for such plans can vary based on investment returns from the account. Some defined contribution plans also place restrictions on payouts. For example, an employee’s contribution is forfeited if he or she does not stay for a prescribed term at the company.
Basics of Defined Contribution Plans
Up until recent times, Social Security was considered an important component of retirement planning. However, as the number of senior citizens dependent on it has increased, social security has become a less viable route to retirement security.
Employer-sponsored defined benefits programs are a possible solution but they are expensive to setup and maintain. As a result, the number of employers providing such programs has declined significantly over the years.
Defined contribution plans have taken the place of benefit programs. Such plans are also known as salary deferral plans because they defer an employee’s current salary for future retirement income. Defined contribution plans ae generally cheaper to set up as compared to benefit plans and employee participation in these plans is voluntary. Most opt for it anyway because the plans offer an array of benefits, such as tax-deferral and greater control over investments.
Defined Contribution Plans generally include one or more of the following elements in their design:
- Automated deductions of contribution amount from salary.
- Employer contributions that are either matching (equal to that of the employee’s contribution) or nonelective (equal to a set amount or percentage of the employee’s salary).
- Vesting schedules for contribution amounts. While some plans offer immediate ownership, others adopt a staggered approach in which ownership of contributions increases with years in service.
- Some investment accounts contained within defined contribution plans are participant-directed, meaning the employees can direct investments for the amount. Others are administrator-directed to enable administrators, generally financial institutions or brokerages, to direct investment decisions. Some plans combine both options or allow employees to work with a qualified investment advisor.
Types of Defined Contribution Plans
Over the years, the popularity of defined contribution plans has surpassed that of Defined Benefit Plans. Several types of plans are now available in the market. Here’s a brief run through some of the of options available to employees:
- 401(k) plans: These are the most common type of defined contribution plans and are offered by most companies. They feature design elements outlined above. According to research, 93% of employers offer 401(k) or one of its variants.
- 403(b) plans: These are retirement plans for employees of schools, healthcare entities, and non-profit ventures.
- 401(a) and 457 plans: Both plans are aimed at government workers and non-profits and they are designed to provide incentives for workers to stay longer with the respective entity. The 457 plan is specifically aimed at state government and municipal workers.
- Thrift Savings Plan (TSP): This is another type of plan for workers in the government sector. It is offered to federal employees. TSPs do not cost much to maintain and the investment approach tends to be extremely conservative.
Advantages and Disadvantages of Defined Contribution Plans
The advantages of defined contribution plans are as follows:
- Tax Benefits: Because employee contributions are made using pre-tax income, most defined contribution plans reduce the taxable income amount. An exception to this rule is Roth IRA in which employees make their contributions with after-tax income. However, even Roth IRAs offer tax benefits by making later required minimum distributions (RMDs) tax-free.
- Control over Retirement Funds: Employees can set their own contribution limits, or percentage of their salary that they would like to save for retirement, in defined contribution plans. Some plans allow employees to direct their investments from within their retirement accounts, allowing them greater control over the retirement planning process.
- Higher contribution limits: Contribution limits are higher for defined contribution limits for defined contribution plans as compared to other instruments. Employees can contribute a maximum of $19,500 per year in 2021 for some defined contribution plans. Those who are 50 or older can set aside another $6,000 for a total of $25,000 per year. Contrast that with the IRA annual limit of $6,000.
- Loans and Hardship Withdrawals: Participants in defined contribution plans can take out loans using funds or assets in their retirement accounts as collateral. Not only this, contribution plans allow for hardship withdrawals for emergency funds. (But the withdrawals come with a 10% penalty and taxes on the amount withdrawn).
- Rollover facilities: You can rollover funds from one plan to another or combine contribution plans with other retirement planning instruments to maximize your returns.
The disadvantages of defined contribution plans are as follows:
- No Federal Insurance: Defined contribution plans are not federally insured. This is unlike defined benefit plans, which have certain amounts protected through federal insurance.
- Dependence on Investment Returns: The final payout in a defined contribution plan depends on investment returns from the retirement account. Therefore, it is not easy to predict or plan for retirement using such accounts.
- Required Minimum Distributions: Most defined contribution plans have RMDs after the age of 72. The RMDs are considered regular income by the IRS and taxed at applicable income tax rates.
- Variance in Vesting Periods: Defined contribution plans have differing vesting periods. Some allow immediate vesting while others, such as government-sponsored plans, might involve staying on at the same institution for several years. These periods can reduce their flexibility and hamper an employee’s career mobility.
Defined Contribution Plan FAQs
About the Author
True Tamplin, BSc, CEPF®
True Tamplin is a published author, public speaker, CEO of UpDigital, and founder of Finance Strategists.
True contributes to his own finance dictionary, Finance Strategists, and has spoken to various financial communities such as the CFA Institute, as well as university students like his Alma mater, Biola University, where he received a bachelor of science in business and data analytics.