Though Social Security provides a fair amount of income to retired workers, most seniors can't survive on those benefits alone. Rather, they need an additional source of income to pay their bills once they're no longer working, and that's where defined contribution plans come in. A defined contribution plan is a retirement plan where employers, employees, or both make regular contributions, and future benefits are based on how much money goes into the plan and how the plan's investments perform. Defined contribution plans typically impose restrictions on when funds can be accessed and assess penalties for early withdrawals. The 401(k) is a well-known example of a defined contribution plan.
How defined contribution plans work
When most people talk about defined contribution plans, they're referring to 401(k)s, which are employer-sponsored plans offered to employees. Other types of defined contribution plans include:
- 403(b) plans for employees of public schools and non-profit organizations
- 457 plans for state and municipal employees, as well as employees of qualified non-profit businesses
- Thrift Savings Plans for federal employees
With a defined contribution plan, you, as an employee, get to decide how much money you want to contribute to your account -- though there are annual contribution limits that depend on your age and are subject to change year after year. Once you determine how much of your earnings you wish to contribute, your employer will facilitate what is typically an automatic transfer into your account.
In many cases, an employer might offer to match a certain percentage of your contributions, but this doesn't always happen. Even with an employer match, the bulk of your defined contribution plan funding comes from you.
Once your account is funded, it will be up to you to decide how to invest your money. Most plans offer a number of investment options, each of which comes with its own risks and fees. Furthermore, once you open an account, you get to maintain ownership of it, even if you switch jobs. But while the money in that plan is yours, there are strict rules regarding the timing of withdrawals. Typically, you'll face a stiff penalty for withdrawing funds prior to reaching age 59-1/2 (though there are a few exceptions).
Depending on the type of plan you open, you may get an up-front tax break for contributing. With a 401(k) plan, for example, the money you contribute goes in on a pre-tax basis and gets to grow tax-deferred until you're eligible for withdrawals.
Defined contribution plans versus defined benefit plans
More commonly known as a pension plan, a defined benefit plan is an employer plan that guarantees employees a specific amount of money in the future. Like defined contribution plans, defined benefit plans come with their own rules regarding withdrawals, and while certain defined benefit plans are co-funded by employers and employees, most are employer-funded.
The primary difference between a defined contribution plan and a defined benefit plan is that with the former, you're not guaranteed a certain amount of money in retirement. With a defined benefit plan, the amount you'll receive is defined (hence the name) and based on factors such as your length of employment and earnings history. Furthermore, with a defined contribution plan, you make your own investment choices and assume all of the risks involved (whereas employers are responsible for investing defined benefit plan assets and taking on whatever risk that entails).
Though defined benefit plans typically offer more financial security than defined contribution plans, they've also grown far less popular in recent years because they're more costly and complicated to maintain. As such, most employees today need to take savings matters into their own hands and contribute to their defined contribution plans if they want to have access to non-Social Security income in retirement.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at email@example.com. Thanks -- and Fool on!
The Motley Fool has a disclosure policy.