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A defined contribution plan is a type of employer sponsored pension plan funded by contributions from employers or employees, or both. Contributions provide employees and employers with valuable tax breaks, and the retirement income of a defined contribution plan depends entirely on the performance of the employee’s investment choices.
How does a defined contribution plan work?
A defined contribution plan is sponsored by an employer, which offers the plan to its employees as part of their benefits. This is called a defined contribution plan because the account is funded by company and employee contributions, although in some cases only the company or employee makes contributions to the plan. diet.
Defined contribution plans come with valuable tax advantages. These can include pre-tax contributions that reduce an employee’s taxable income – plus potential tax deductions for the employer – or, alternatively, after-tax Roth contributions that give an employee non-taxable income in retirement. . In all cases, contributions are tax-sheltered as long as they remain in an employee’s account.
Companies that offer a defined contribution plan organize the plan for employees and choose the various options offered by the plan. The company selects the type of plan to offer, chooses the menu of investments available in the plan, and decides whether or not to deposit funds into its employees’ accounts. Employer contributions can include profit sharing, safe haven contributions, or matching employee contributions.
Employees can decide whether or not they want to participate in their employer’s defined contribution plan. If they choose to participate, they decide what percentage of their salary to pay and select different investments for their own account, most often an organized selection of mutual funds and index funds.
Income in retirement depends entirely on the contributions saved in the account and the performance of an employee’s investment choices.
Defined benefit plan vs defined contribution plan
Defined contribution plans operate very differently from defined benefit plans. Where a defined contribution plan places most of the responsibility for contributions and investment management on the employee, a defined benefit plan places these responsibilities on the employer.
A defined benefit plan guarantees a specific amount of money that employees can expect to receive as income each month in retirement, whether that is an exact dollar amount or a percentage of average salary. over particular income years.
The defined benefit plan you are probably most familiar with is a traditional pension plan. Typically, employers make the bulk of contributions to a traditional pension plan, rather than the employee.
Pension plans were once common in the workplace – at one point the vast majority of workers in the private sector had one. Today, only 21% of workers participate in a pension scheme, and these are largely state and local government officials. Twice as many workers (43%) participate in a defined contribution scheme.
Defined contribution plans are largely funded by employee contributions and do not offer any guaranteed return on retirement income. Unlike defined benefit plans, however, they generally provide the employee with control over the investments made with contributions to the plan.
Benefits of defined contribution plans
A defined contribution plan offers certain advantages, ranging from tax advantages to high contribution limits.
• Automated retirement savings. Once an employee has opted for a defined contribution plan, contributions are automatically deducted from their paychecks on a regular schedule. This allows plan members to automate their retirement savings.
• Fiscal advantages. Whether you choose a traditional or Roth defined contribution plan, you’ll get some sort of tax break and your investments will grow tax-free until you start withdrawing money in retirement. .
• Correspondence with the potential employer. Many defined contribution plans allow employers to match a portion of an employee’s contribution, such as a 100% match of the first 3% of your salary that you pay.
• High contribution limits. While contributions to an Individual Retirement Account (IRA) are capped at $ 6,000 per year in 2020 and 2021 (or $ 7,000 if you’re 50 or older), employees can save up to $ 19,500 in defined contribution plans like a 401 (k) or 403 (b), plus an additional $ 6,500 if they are 50 or older. Employer contributions to 401 (k), 403 (b) and other defined contribution plans can reach $ 57,000 in 2020 and $ 58,000 in 2021.
Disadvantages of defined contribution plans
A defined contribution plan, however, is not without its drawbacks.
• No guaranteed income. Unlike a defined benefit pension, there is no guaranteed payout at the end of your defined contribution rainbow. Since contributions are invested in the market, they are subject to investment risks and market volatility.
• High fees. Some defined contribution plans have high fees. These may include plan administration fees, investment fees and individual service fees. If your plan has excessively high fees, experts usually recommend that you invest enough to get matched contributions from your employer and invest the rest of your pension contributions in an IRA.
• Limited investment options. Defined contribution plans may offer limited investment choices, depending on the selection of funds offered by the employer. If you’re not happy with the investment options in your plan, consider saving some of your retirement funds in an IRA, which usually offers more options.
• Acquisition of employer contributions. Some defined contribution plans require that an employee stay with a company for a number of years before acquiring full ownership of employer contributions. About half of 401 (k) plans have some sort of vesting schedule.
• Minimum distributions required. Most defined contribution plans require that you start receiving distributions once you are 72, whether or not you need the income. Called minimum required distributions (RMD), they can increase your taxable income. You may be able to reduce your RMD with a Roth IRA rollover or by purchasing a Qualified Longevity Annuity Contract (QLAC).
Types of defined contribution plans
Many of the pension plans you are already familiar with are defined contribution plans. Although there are a variety of defined contribution plans, most of them offer very similar characteristics; their different names mainly indicate the types of companies by which they are sponsored. Types of defined contribution plans include:
• 401 (k). This is the most common defined contribution plan. Offered by for-profit companies of all sizes, 401 (k) are funded by pre-tax employee contributions as well as matching or non-matching contributions from employers.
• Roth 401 (k). This version of 401 (k) allows employees to contribute after tax. Businesses cannot put matching funds into Roth accounts, so employer contributions are placed in a top-up 401 (k) if you opt for a Roth 401 (k).
• 403 (b) and 457 regimes. These plans are offered by government agencies, public educational institutions, some nonprofit and religious organizations. The 403 (b) and 457 plans can offer Roth accounts.
• SEP IRA. Designed for the self-employed and small businesses, PESs require employers to contribute the same percentage of salary to each participating employee’s plan. Employees do not make contributions and Roth options are not available.
• SINGLE ARI. Designed for businesses with 100 or fewer employees, SIMPLE IRAs can provide employer matching or require employer contributions, regardless of employee participation. Employees are still able to contribute to a SINGLE IRA. Roth accounts are not available.
• Savings savings plans (PST). Available to federal government employees and uniformed service members, TSPs allow employers and employees to contribute. Roth accounts are available, but investment options are generally more limited than in other defined contribution plans.
• Incentive plans. These plans are funded solely by contributions from the employer, usually from the income of a business. Each employee typically receives a percentage of the earnings, although contribution amounts may change depending on the overall profitability of the business.
• Money purchase plans / 401 (a). Money purchase plans work like incentive plans, except employers make fixed annual contributions to each employee’s account, regardless of income and profitability in a given year. Employees may be required to contribute a percentage of their salary. 401 (a) plans are money purchase plans for government agencies, public educational institutions, and non-profit organizations.
• Employee share ownership plans (ESOP): These plans are funded by actions of an employer.
Contribution limits for defined contribution plans
Contributions from employees or employers – or both – are at the heart of all defined contribution plans. Defined contribution plans, however, have limits for employer and employee contributions.
• 401 (k), 403 (b), most 457 plans and Thrift Savings Plans. In 2020, plan members can contribute up to $ 19,500 per year if they are under 50. Those over 50 can contribute an additional $ 6,500. Employers can contribute up to 25% of an employee’s compensation, but the total employee and employer contributions cannot exceed $ 57,000 ($ 63,500 if 50 or older) in 2020 or 58 $ 000 ($ 64,500 if 50 years or older) in 2021.
• Incentive plans: Employers can contribute up to the lesser of 25% of earnings or $ 58,000 in 2021 ($ 57,000 in 2020).
• Money purchase plans / 401 (a) plans: Employers and employees can contribute up to a total of 25% of an employee’s net earnings or $ 58,000 in 2021 ($ 57,000 in 2020), whichever is less.
• SIMPLE packages: Participants can contribute up to $ 13,500 in 2020. Those over 50 can contribute an additional $ 3,000.
• SEP IRA: SEPs do not allow employee contributions, but your employer can contribute up to the lesser of $ 58,000 in 2021 ($ 57,000 in 2020) per year or 25% of your salary.