What is a Defined Contribution (DC) Plan?
A defined contribution (DC) plan is a tax-deferred retirement plan, such as a 401(k) or 403(b), where employees contribute a fixed amount or percentage of their paychecks into an account designated for retirement. To sweeten the deal, the employer often matches a portion of these contributions.
However, there are rules governing when and how employees can withdraw from these accounts without penalties.
Key Takeaways
- Defined contribution (DC) plans allow you to invest pre-tax dollars in the capital markets, growing tax-deferred until retirement.
- Popular DC plans include 401(k) and 403(b), commonly used to encourage employees to save for retirement.
- Unlike defined benefit (DB) pensions, DC plans offer no guarantees; participation is voluntary and self-directed.
Effective Strategy for Defined Contribution (DC) Plans
You won’t know the exact amount your DC plan will provide upon retirement, as contribution levels and investment returns can fluctuate over the years. As of Dec. 31, 2021, DC plans accounted for $11 trillion of the $34.2 trillion in total U.S. retirement plan assets.
Unlike a defined benefit (DB) pension plan, which guarantees specific benefits, DC plans invest pre-tax dollars to grow in the capital markets. Taxes are only due upon withdrawal at retirement age (minimum 59½ years), with required minimum distributions starting at age 73.
The strategy is to take advantage of lower tax brackets upon retirement compared to your earning years. It’s important to remember that early withdrawals before 59½ may incur a 10% penalty, unless certain exceptions apply.
Unlocking the Power of DC Plans
Advantages of Participating in a DC Plan
- Pre-tax contributions: DC plan contributions grow tax-deferred until withdrawal. With a Roth 401(k), contributions are post-tax, but withdrawals are tax-free if certain conditions are met.
- Employer matching: Many employers offer matching contributions, often $0.50 per $1 contributed up to a specific percentage. Maximizing these matches provides ‘free money’ that compounds over time.
- Additional benefits: Features like automatic enrollment, contribution increases, hardship withdrawals, loans, and catch-up contributions for those aged 50 and older.
Limitations of DC Plans
- Self-management: Employees must manage their own investments. This can be challenging for individuals with little experience in stocks, bonds, and other asset classes, potentially leading to poorly diversified portfolios.
- No guaranteed income: Unlike DB pension plans, DC plans do not guarantee a lifetime income. A vast number of participants may not contribute enough regularly to sustain their retirement needs.
Opportunities and Variations of DC Plans
Diverse DC Plan Options
- 401(k) Plans: Typically available to employees of publicly-owned companies.
- 403(b) Plans: Suitable for employees of nonprofit organizations, such as schools.
- 457 Plans: Available to specific nonprofit business employees and state/municipal employees.
- Thrift Savings Plan (TSP): For federal government employees.
- 529 Plans: Aimed at funding child education but can also act as a retirement savings option.
- IRAs: Defined contributions in tax-advantaged accounts with no specific retirement income guarantees.
Defined Contribution vs. Defined Benefit Plans
- Guaranteed Income vs. Self-Directed Savings: DB plans provide a predetermined retirement income based on various factors (length of employment, salary history), guaranteeing benefits. DC plans, however, offer no income guarantee and depend on individual contributions and investment performance for retirement savings.
Cashing Out DC Plan
It’s generally required to keep funds in the DC plan until reaching 59½, or face a 10% penalty plus applicable income taxes for premature withdrawals.
Maximum Contributions
Under-50 participants in 401(k) plans can contribute up to $22,500 annually in 2023. Those over 50 can contribute an additional $7,500 as catch-up contributions.
Conclusion
Defined contribution plans allow both employers and employees to contribute specific amounts regularly towards retirement. Popular DC plans include 401(k), 457, and 403(b) plans, necessitating investment options tailored to individual retirement goals (high-return, high-risk or low-risk, low-return portfolios). Optimizing contributions and investment choices ensures a financially secure retirement.
Related Terms: Defined Benefit Plan, Individual Retirement Account,.
References
- U.S. Department of Labor. “Types of Retirement Plans”.
- Investment Company Institute. “2022 Investment Company Fact Book”, Pages 6, 143.
- Internal Revenue Service. “A Guide to Common Qualified Plan Requirements”.
- Internal Revenue Service. “Retirement Plan and IRA Required Minimum Distributions FAQs”.
- Internal Revenue Service. “Retirement Topics - Exceptions to Tax on Early Distributions”.
- Internal Revenue Service. “Retirement Plans FAQs on Designated Roth Accounts”.
- U.S. Congress. “H.R.2954 - Securing a Strong Retirement Act of 2022”.
- Internal Revenue Service. “Retirement Topics - Catch-Up Contributions”.
- Vanguard. “How America Saves”, Page 6.
- Internal Revenue Service. “401(k) Plan Overview”.
- Internal Revenue Service. “IRC 403(b) Tax-Sheltered Annuity Plans”.
- Internal Revenue Service. “401(k) Limit Increases To $22,500 for 2023, IRA Limit Rises To $6,500”.
