What is a defined contribution plan?
A defined contribution plan is a type of retirement savings plan. With this kind of plan, you and the company you work for both put money into a special account to save for your retirement. The money that gets put into the account is then invested so that it can grow over time. When you retire, you get all the money that has built up in your account. This includes the money you put in, the money your employer put in, and any money the account made from the investments.
How does it work?
Here’s a simple way to understand how a defined contribution plan works:
- You decide how much money you want to take out of each paycheck and put into the plan. This is usually a percentage of what you make, like 5% or 10%.
- Your employer also puts money into the plan for you. Sometimes, they match what you put in. So, if you put in 5%, they might also put in 5%.
- The money that goes into the plan gets invested. You usually get to choose from different investment options, like stocks or bonds.
- Over time, the investments can make money. This money gets added to your account balance.
- When you retire, you get to take the money out of the account. You can take it all at once or a little bit at a time. The money is meant to help pay for things when you’re no longer working.
The key thing about defined contribution plans is that what you get when you retire depends on how much money was put into the account over the years and how well the investments did. Unlike some other kinds of retirement plans, there are no guarantees about exactly how much you’ll get. That’s why it’s called a “defined contribution” plan – what’s defined is how much goes in, not how much comes out at the end.
401(k) plans
In the United States, the most common type of defined contribution plan is called a 401(k) plan. If you have a job, there’s a good chance your employer offers a 401(k). Here’s what you should know about them:
Putting money in
With a 401(k), you tell your employer how much you want to contribute from each paycheck. They take this money out before calculating taxes. This is good because it means you don’t pay income taxes on the money you contribute. The taxes are “deferred” until later when you take the money out.
There are limits to how much you can put into a 401(k) each year. In 2023, you could contribute up to $22,500 if you’re under 50 years old. If you’re 50 or older, you could put in an extra $7,500 as a “catch-up” contribution. These limits can change from year to year.
Employer matching
One of the best things about 401(k) plans is that many employers will match some of the money you put in. They might match a percentage of your contributions up to a certain amount. For example, they could match 50% of what you put in, up to 6% of your salary.
So let’s say you make $50,000 a year and contribute 6% of your salary, which is $3,000. If your employer matches 50% of that, they would put in an extra $1,500. That’s free money! It’s a very good idea always to contribute at least enough to get the full employer match.
Investing the money
The money in your 401(k) gets invested so it can grow. Most plans offer a menu of different investment options you can choose from. These often include:
- Mutual funds that invest in stocks
- Mutual funds that invest in bonds
- Target date funds that automatically adjust as you get closer to retirement
- Stable value funds that focus on preserving your money
It’s important to choose investments that fit your goals and risk tolerance. Generally, when you’re younger, you can afford to take more risk, because you have time to ride out the ups and downs of the market. As you get closer to retirement, you might want to shift to safer investments.
Taking money out
In general, you’re supposed to leave the money in your 401(k) until you reach retirement age, which is 59 1/2. If you take money out before then, you usually have to pay a 10% penalty plus income taxes on the money you withdraw.
There are a few exceptions to this rule. For example, if you have a serious financial hardship, you might be able to take money out early without a penalty. And if you leave your job, you can roll your 401(k) over into an IRA or a new employer’s plan without paying any penalties or taxes.
When you do retire, you have a few options for how to take the money. You can:
- Take it all out at once (but you’ll have to pay a lot in taxes!)
- Take out a little bit each month or year
- Convert it into an annuity that pays you a set amount for life
Your 401(k) provider can help you understand your options.
Other types of defined contribution plans
While 401(k)s are the most common, there are a few other types of defined contribution plans you might encounter:
403(b) plans
These are very similar to 401(k) plans, but they’re for employees of non-profits, schools, and religious organizations. The contribution limits and rules are generally the same as for 401(k)s.
457 plans
These are for state and local government employees. Again, they work similarly to 401(k)s.
Thrift Savings Plan (TSP)
If you’re a federal employee or in the military, you might have access to the TSP. It’s the government’s version of a 401(k).
Solo 401(k)
If you’re self-employed or own a business with no employees, you can set up a solo 401(k). This lets you contribute as both the employee and the employer.
SIMPLE and SEP IRAs
These are simplified retirement plans that small businesses can offer. They have lower contribution limits than 401(k)s.
The advantages of defined contribution plans
There are several reasons why defined contribution plans have become so popular:
Portability
One of the biggest advantages is that they’re portable. If you leave your job, you can take your 401(k) with you. You can roll it over into an IRA or a new employer’s plan. This is a lot easier than with traditional pension plans, where you often lose your benefits if you leave before a certain age.
Investment control
With a defined contribution plan, you have control over how your money is invested. You can choose from the options your plan provides and change your investments as your needs change. This can be good if you like having that control (but it can also be daunting if you’re not comfortable making investment decisions).
Potential for growth
Because the money in a defined contribution plan is invested, there’s the potential for it to grow significantly over time. If you start contributing early in your career and invest wisely, you could end up with a lot more money than you put in.
Tax advantages
Contributions to most defined contribution plans are made pre-tax. This means you don’t pay income taxes on the money you put in (you will pay taxes when you take the money out in retirement). This can lower your tax bill each year you contribute.
Many plans also offer a Roth option. With a Roth, you contribute after-tax dollars, but your withdrawals in retirement are tax-free. This can be a good choice if you think you’ll be in a higher tax bracket in retirement.
The disadvantages of defined contribution plans
While defined contribution plans have a lot going for them, there are some potential downsides to consider:
No guaranteed income
With a defined contribution plan, there’s no guarantee of how much income you’ll have in retirement. It all depends on how much you (and your employer) put in and how well your investments perform. This can make it hard to plan for retirement.
Investment risk
When you have a defined contribution plan, you bear the investment risk. If your investments do poorly, you could end up with a lot less money than you expected. This is different from a traditional pension plan, where the employer bears the investment risk.
Fees
Many 401(k) plans have fees that can eat into your returns. These might include administrative fees, investment management fees, and fees for individual services like loans or hardship withdrawals. Over time, even small fees can have a big impact on your account balance.
Limited investment options
While you do have control over how your money is invested in a defined contribution plan, you’re limited to the options your plan provides. These might not be the best or cheapest funds available.
Difficult decisions
Deciding how much to contribute, how to invest, and how to take your money out in retirement can be complicated decisions. Many people find it challenging to manage their retirement savings effectively.
Making the most of your defined contribution plan
If you have access to a defined contribution plan, it’s important to make the most of it. Here are some tips:
Start early
The earlier you start contributing to your plan, the more time your money has to grow. Even small contributions can make a big difference over time.
Contribute as much as you can
Try to contribute as much as you can afford, especially if your employer offers a match. Aim to contribute at least enough to get the full match – that’s free money!
Consider increasing your contributions over time
As you get raises or pay off debts, consider increasing the percentage you contribute to your plan. Even a 1% increase can make a big difference over the course of your career.
Choose your investments wisely
Take the time to learn about your investment options and choose a mix that fits your goals and risk tolerance. Consider factors like your age, when you plan to retire, and how comfortable you are with market fluctuations.
Don’t take money out early
Try to avoid taking money out of your plan before retirement. Not only will you pay penalties and taxes, but you’ll also miss out on potential growth.
Review your plan regularly
Check in on your account at least once a year. See how your investments are doing, and consider whether you need to make any changes. As you get closer to retirement, you might want to shift to a more conservative investment mix.
Get advice if you need it
If you’re not sure how to manage your defined contribution plan, consider getting advice from a financial professional. Many plans offer access to advice services, often for a fee. A good advisor can help you make informed decisions about your retirement savings.
Final Thoughts
Defined contribution plans have become the primary way that many people save for retirement. By understanding how they work and making the most of them, you can build a solid foundation for your financial future. Remember, it’s never too early (or too late) to start saving and investing for retirement. Every little bit helps, and over time, small contributions can grow into a significant nest egg. So, if you have access to a 401(k) or another type of defined contribution plan, take advantage of it. Your future self will thank you.
