What Are Defined Contribution Plans, and How Do They Work?

What Is a Defined Contribution (DC) Plan?

A defined contribution (DC) plan is a retirement plan that's typically tax-deferred, like a 401(k) or a 403(b), in which employees contribute a fixed amount or a percentage of their paychecks to an account that is intended to fund their retirements. In addition, the sponsor company can match a portion of employee contributions as an added benefit.

These plans place restrictions that control when and how each employee can withdraw from these accounts without penalties.

Understanding Defined Contribution (DC) Plans

There is no way to know how much a DC plan will ultimately give the employee upon retiring, as contribution levels can change, and the returns on the investments may go up and down over the years.

DC plans accounted for $11 trillion of the $34.2 trillion in total retirement plan assets held in the United States as of Dec. 31, 2021, according to the Investment Company Institute (ICI). The DC plan differs from a defined benefit (DB) plan, also called a pension plan, which guarantees participants receive a certain benefit at a specific future date.

DC plans take pre-tax dollars and allow them to grow capital market investments tax-deferred. This means that income tax will ultimately be paid on withdrawals, but not until retirement age (a minimum of 59½ years old, with required minimum distributions (RMDs) starting at age 73).

The idea is that employees earn more money and thus are subject to a higher tax bracket as full-time workers and will have a lower tax bracket when they are retired. Furthermore, the income earned inside the account is not subject to taxes until the account holder withdraws it. If it's withdrawn before age 59½, a 10% penalty will apply unless exceptions are met.

Advantages of Participating in a DC Plan

Contributions made to a DC plan may be tax-deferred until withdrawals are made. In the Roth 401(k), the account holder makes contributions after taxes, but withdrawals are tax-free if certain qualifications are met. The tax-advantaged status of DC plans generally allows balances to grow larger over time compared to accounts that are taxed every year, such as the income on investments held in brokerage accounts.

Employer-sponsored DC plans may also receive matching contributions. The most common employer matching contribution is $0.50 per $1 contributed up to a specified percentage, but some companies match contributions dollar for dollar up to a percentage of an employee's salary, generally 4% to 6%. If your employer offers matching on your contributions, it is best to contribute at least the maximum amount they will match, as this is essentially free money that will grow over time and will benefit you in retirement.

Other features of DC plans include automatic participant enrollment, automatic contribution increases, hardship withdrawals, loan provisions, and catch-up contributions for employees aged 50 and older.

Limitations of DC Plans

DC plans, like a 401(k) account, require employees to invest and manage their own money to save up enough for retirement income later in life. Employees may not be financially savvy or have any other experience investing in stocks, bonds, and other asset classes. This means that some people may invest in improperly managed portfolios—for instance, a portfolio that includes too high of a ratio of their own company's stock rather than a well-diversified portfolio of various asset class indices.

Unlike defined benefit (DB) pension plans, which are professionally managed and guarantee retirement income for life from the employer as an annuity, DC plans have no such guarantees. Many workers, even if they have a well-diversified portfolio, are not putting enough away regularly and will find that they do not have enough funds to last through retirement.

DC Plan Examples

The 401(k) is perhaps most synonymous with the DC plan, but many other options exist. The 401(k) plan is available to the employees of publicly-owned companies. The 403(b) plan is typically open to employees of nonprofit corporations, such as schools.

Notably, 457 plans are available to employees of certain types of nonprofit businesses as well as state and municipal employees. The Thrift Savings Plan (TSP) is used for federal government employees, while 529 plans are used to fund a child's college education.

Since individual retirement accounts (IRAs) often entail defined contributions into tax-advantaged accounts with no concrete benefits, they could also be considered a DC plan.

The Bottom Line

Defined contribution plans are retirement plans where the employer, employee, or both make regular contributions of specified amounts. Many popular plans are defined contribution plans, such as the 401(k), 457, and 403(b) plans.

These plans generally require the employees to choose from investment options to fit their retirement goals, such as portfolios with higher returns and risk or more conservative portfolios with lower risk and returns.