LAST REVIEWED Jul 14 2020 9 MIN READ
By The Human Interest Team
401(k) plans, 403(b) plans, and other common retirement accounts fall under a broad category of plans called “defined contribution plans.” In this article, we’ll discuss what these plans are, their advantages, and how they differ from defined benefit plans.
What Is a Defined Contribution Plan?
While Social Security benefits go to nearly one in five people across the United States, those funds aren’t sufficient for recipients to survive only on social security. Instead, many retired workers use a combination of Social Security benefits and defined contribution plans.
In defined contribution plans, both employers and employees make contributions. The pre-tax contributions grow without accruing any taxes, and employees will pay regular income taxes on any qualifying withdrawals when they reach 59 1/2 years old.
In savings and thrift plans, one of the most popular defined contribution plans, employees contribute a set portion of their pre-tax income to the account, and employers match that contribution. Defined contribution plans, in general, are increasingly becoming popular alternatives to pensions. While defined contribution plans are similar to defined benefit plans, they are more portable. Participants don’t need an actuary to determine the liability.
In these plans, the employees assume most of the risk. They choose their own investments and accept the risk of potentially volatile markets and stocks. Because of this volatility, the “benefits” portion of the plan isn’t calculated until the employee decides to start using the assets. However, the employer does take on some degree of fiduciary responsibilities. They select the available investment options and who the administrative provider of the plan is.
These are different from defined benefit plans, which are professionally managed so employees don’t have to research investment options. Defined benefit plans include the guarantee of lifelong retirement income for employees, which defined contribution plans don’t promise.
Advantages of Participating in a Defined Contribution Plan
Defined contribution plans offer several advantages over pension plans and other savings plans. These advantages include:
Tax deferrals: Employees can contribute pre-tax dollars, which means they don’t have to pay income taxes the year they make the contribution. Instead, they only have to pay taxes when they make withdrawals during retirement. This is widely regarded as more financially strategic since working individuals tend to be in a higher income tax bracket when they’re working as opposed to during retirement.
Matching contributions: If an employer is sponsoring the plan, like in the case of savings and thrift plans, the employee may receive employer matching contributions. One of the most commonly used formulas for employer matches is for employers to contribute 50 cents for every $1 an employee contributes up to a set cap. That cap is generally 4-6% of the employee’s compensation.
Catch-up contributions: Older employees can make greater contributions to save for retirement. Most defined contribution plans have a maximum cap that employees can contribute, such as $20,500 for 401(k) plans, and individuals who are older than 50 can make an additional $6,500 contribution.
Different defined contribution plans also offer additional features, such as loan allowances, simple enrollment processes, and hardship withdrawals.
How Do Defined Contribution Plans Work?
Qualifying employees can create individual accounts through their employer’s plan and fund the account through contributions (as well as employer contributions, when available). The benefits that grow because of those contributions depend on the market, pre-established growth factors, and the total rate of contribution. As investments in the market fluctuate, so do earnings in defined contribution plans.
Most employees organize their contributions as regular transfers that are pulled from their check automatically. Employers with contribution matching plans will also transfer funds over on a fixed basis. Employees can then choose where those funds will be invested, based on the pool of options the employer plan allows for.
These accounts follow employees, even when they leave an employer. At this point, employees can “cash out” their plan (which comes with a 10% penalty tax if the employee isn’t over 59 1/2 years old), roll it over into an IRA, or roll it over in a new 401(k) plan through their new employer.
However, the employer’s contributions may not be fully owned by the employee if they were only employed for a short period of time. Employers often establish vesting periods before an employee owns 100% of the employer’s contributions. For example, an employee who works at a company with a four-year vesting period might only roll over 25% of the employer’s contributions if they leave after one year of employment.
Limitations of Defined Contribution Plans
One of the biggest challenges for defined contribution plans like 401(k) plans is that employees must manage their investments and risks themselves. They must be able to choose reasonable investment options between multiple different types of stocks, funds, and bonds, and some employees won’t create properly diversified holdings.
Employees also have to save based on their own needs and expectations. While individuals can contribute up to a set cap each year for retirement, and older employees can contribute even more, there is no guarantee that employees will proactively save and invest.
Types of Defined Contribution Plans
Some of the most popular defined contribution plan types include:
401(k) Plans: These plans are for public corporation employees.
403(b) Plans: These plans are for nonprofit organization employees.
457 Plans: These plans are for state, municipal, and some nonprofit employees.
Profit-Sharing Plans: These plans are funded by employer profits.
Money Purchase Plans: These plans have fixed employer contributions that aren’t tied to company performance.
Employee Stock Ownership Plans: These plans offer employer stock investment options.
Savings Incentive Match Plans for Employees (SIMPLE): These plans are specifically for businesses with 100 or fewer employees.
Thrift Savings Plans: These plans are for federal employees.
Defined Contribution Plans vs. Defined Benefit Plans
Defined benefit plans, or pensions, guarantee employees set amounts of income throughout retirement. The amount of income is determined by your earnings and employment length, and most of the contributions are from the employer. Defined contribution plans don’t make guarantees about the income employees will receive during retirement.
Defined benefit plans can be costly and complex, which is why more and more companies are turning to defined contribution plans like 401(k) plans. In fact, only 20% of Americans had access to defined benefit plans in 2008.
To learn more about the different types of defined contribution plans your company can offer employees, talk to Human Interest today. We’re here to help.
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The Human Interest Team
We believe that everyone deserves access to a secure financial future, which is why we make it easy to provide a 401(k) to your employees. Human Interest offers a low-cost 401(k) with automated administration, built-in investment education, and integration with leading payroll providers.