Definition and Examples of Defined Contribution Plans
How Defined Contribution Plans Work
Alternatives to Defined Contribution Retirement Plans
Definition and Examples of Defined Contribution Plans
Defined contribution plans are tax-advantaged retirement plans managed by employers. The most common types are 401(k) and 403(b) plans. Employers often match a portion of the employee’s contribution either fully or partially.
How Defined Contribution Plans Work
401(k) and 403(b) plans are popular accounts used by employers to help their employees save for retirement. Each employer has different rules for their plans. In many cases, if the employee contributes a certain amount, the employer will match that amount or a portion of it. Many financial advisors recommend taking advantage of defined contribution plans since the matching amount is a benefit that cannot be obtained in other ways.
Vesting
Many employers have vesting schedules tied to their matching programs, meaning that the employee does not fully own the account until they are vested after a certain period of time. Vesting restricts the amount an employee can take if they leave the company. For example, with a five-year vesting period, 20% of the total matching funds will vest each year. If the employee leaves the company after three years, they will only receive 60% of the matching funds.
Other Types of Defined Contribution Plans
In addition to 401(k) and 403(b) plans, there are two other common types of defined contribution plans: profit-sharing plans and employee stock ownership plans.
In a profit-sharing plan, the employer contributes a single contribution, which is optional. Often, the employer will specify a percentage of profits to be shared with employees, and then this amount is contributed to their accounts each year.
In employee stock ownership plans, the company offers shares from its own company to employees. This differs from employee stock option plans where the employee must pay money to purchase the shares.
Alternatives to Defined Contribution Plans
The main alternative to a defined contribution plan is a defined benefit plan, also known as a pension. Retirement funds can be structured in various ways, but generally, the employee must meet a certain number of years to earn the pension. The longer an employee works for the company, the larger the retirement payout at the end of their career. Upon retirement, the pension is typically paid monthly, but in some cases, the employee may choose a lump sum instead.
Employers have steadily moved away from defined benefit retirement plans due to the liability attached to them. Under defined benefit plans, the company bears the risk and must invest the funds to pay out pensions to employees indefinitely. In contrast, defined contribution plans shift the risk to the employee, who must then make smart investments.
Note: If the pension plan is not well-funded or if the company goes bankrupt, employees could find themselves in a difficult situation after many years of retirement. It is always wise for employees to have backup retirement plans.
Employees may find it more beneficial to use a defined contribution plan where they can maximize contributions and make conservative investments.
Employees who want a backup plan or work in places that do not offer retirement benefits can benefit from using an Individual Retirement Account (IRA). IRAs are tax-advantaged retirement accounts that allow individuals to invest a certain amount each year and then withdraw the balance in retirement.
Source:
https://www.thebalancemoney.com/what-are-defined-contribution-plans-5205412
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