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Defined Contribution Plan Basics

by Nehemiah Marcus

An employer-sponsored retirement plan that receives funding from both employers and employees is known as a defined contribution plan. In a defined contribution plan, your retirement savings are invested in the stock market, and your contributions may qualify you for significant tax benefits.

Disclosure: This article was paraphrased from annother article on Forbes and repurposed for educational use. It’s designed to encourage people to seek professional financial advice through our short Finance Quiz. You can access the original article link at the bottom of this page.

What Is the Process of a Defined Contribution Plan?

An employer sponsors a defined contribution plan, which is often made available to its employees as a significant component of their employment perks. 

The account is funded by contributions from both the employer and the employee, hence the name “defined contribution plan”—although in some circumstances, only the employer or the employee contributes to the plan. 

Plans with defined contributions have significant tax advantages. These could be post-tax Roth contributions, which provide an employee with tax-free income in retirement, or pretax Roth contributions, which lower an employee’s taxable income and may result in tax deductions for the employer.

In either case, taxation is postponed while contributions are held in an employee’s account. 

Companies chose from among the different alternatives provided by the plan and administered defined contribution plans on behalf of their employees. Employers have the option of contributing to their employees’ accounts or not. Profit sharing, safe harbor contributions, and matching contributions are all examples of employer contributions. 

The defined contribution plan offered by an employer is open to employee participation. If employees decide to participate, they determine how much of their pay to put toward the plan and choose various investments for their personal accounts, typically a carefully chosen mix of mutual funds and index funds.

Retirement income is totally based on the contributions made to the account and the performance of the employee’s chosen investments.

Comparing Defined Contribution and Defined Benefit Plans

Plans with defined contributions operate considerably differently from those with defined benefits. A defined benefit plan is entirely managed by the employer, as opposed to a defined contribution plan where the employee is primarily responsible for making contributions and monitoring investments. 

A defined benefit plan, whether it be an exact dollar amount or a percentage of salary averaged over particular working years, promises a specific amount of money that employees can expect to receive as income each month in retirement. 

A classic pension plan is the type of defined benefit plan you are most likely most familiar with. Typically, companies rather than employees contribute the majority of funds to a traditional pension plan.

Historically, most employees in the private sector had access to pension schemes at their place of employment. Only 21% of workers today engage in a pension plan, and they are mostly employees of municipal and state governments. A defined contribution plan has twice as many participants (43%) than a pension plan. 

Defined contribution plans do not provide a guaranteed return of income in retirement and are primarily funded by employee payments. They typically give the employee authority over the investments made using the plan contributions, in contrast to defined benefit plans.

Pros of Defined Contribution Plans

A defined contribution plan has a number of benefits, including high contribution limits and tax advantages.

Automated saves for retirement. When an employee chooses to participate in a defined contribution plan, contributions are routinely withheld automatically from their paychecks. Participants in the plan can use this to automate their retirement savings. 

Tax advantages. You will get some form of tax savings whether you select a regular or Roth defined contribution plan, and your investments will grow tax-free until you start taking withdrawals in retirement. 

Employer compatibility. In many defined contribution plans, employers can match a part of an employee’s contributions, for example, 100% of the first 3% of your salary.

High contribution thresholds. Employees can save up to $20,500 in 2022 ($22,500 in 2023) in defined contribution plans like a 401(k) or 403(b), plus an additional $6,500 in 2022 if they’re 50 or older ($7,500 in 2023 if they’re 50 or older). Contributions to an individual retirement account (IRA) are capped at $6,000 per year in 2022 and $6,500 per year in 2023 (or $7,000 in 2022 and $7,500 in 20 $61,000 in 2022, $66,000 in 2023, or $67,500 in 2022 if you’re 50 or older, and $73,500 in 2023 if you’re 50 or older, are the total contributions from the company and the individual.

Cons of Defined Contribution Plans

However, a defined contribution plan is not without its disadvantages.

No income assurance. There is no guaranteed payout at the conclusion of your defined contribution rainbow, in contrast to a defined benefit pension. Contributions are exposed to investment risks and market volatility because they are invested in the stock market. 

Costly fees. Certain defined contribution plans have expensive costs. These could include investment fees, plan administration costs, and individual service fees. Experts normally advise investing enough to qualify for any company matching contributions and putting the remaining retirement contributions into an IRA if your plan has extremely high fees.

A lack of investment choices. Depending on the variety of funds a business offers, defined contribution plans might only give a small number of investment options. Consider putting a portion of your retirement assets in an IRA, which typically provides more possibilities, if you are dissatisfied with your plan’s investment choices. 

Vesting of employer contributions. In some defined contribution plans, an employee must work for the company for a certain period of time before being fully responsible for employer contributions. Most 401(k) plans have some kind of vesting schedule, around half of them.

Minimum distribution requirements. Regardless of whether you need the money, most defined contribution plans mandate that you begin drawing distributions after you turn 72. These can raise your taxable income and are known as required minimum distributions (RMDs). With a Roth IRA rollover or the purchase of a qualified longevity annuity contract, you might be able to lower your required minimum distributions (QLAC).

Defined Contribution Plan Choices

You probably already know that defined contribution plans make up a large portion of retirement plans. Defined contribution plans come in many forms, but they all have many of the same benefits; the differences between them are mainly due to the kind of businesses that sponsor them. Defined contribution plan varieties include:

401(k). The most popular defined contribution plan is this one. 401(k) plans, which are available from for-profit businesses of all sizes, are funded by pre-tax contributions from employees as well as matching or non-matching contributions from employers. 

Roth 401(k). Employees may make after-tax contributions to this 401(k). If you choose a Roth 401, employer contributions are made into a supplementary 401(k) because businesses cannot make matching payments to Roth accounts (k). 

Plans 457(b) and 403(b). Governmental entities, public educational institutions, certain nonprofits, and religious organizations all provide these strategies. Roth accounts may be available for both 403(b) and 457 plans.

The SEP IRA. SEPs mandate that employers contribute the same amount of each participating employee’s pay to their plan. They are intended for self-employed people and small firms. Roth options are not offered, and no contributions are made by the employees. 

SIMPLE IRA. In spite of employee participation, SIMPLE IRAs, which are intended for businesses with 100 or fewer employees, may offer employer matching or mandate employer contributions. A SIMPLE IRA is always open to employee contributions. There are no Roth accounts available. 

Thrift Savings Plan (TSP). A TSP enables both employers and employees to contribute and is accessible to both federal government employees and active military personnel. There are Roth accounts accessible, but they often have fewer investing possibilities than other defined contribution plans.

Plans for profit-sharing. Only employer payments, often from business earnings, are used to fund these schemes. Each employee typically receives a portion of earnings, though contribution levels may vary depending on how profitable a company is overall. 

401(k) and money purchase plans (a). Similar to profit-sharing plans, money purchase plans work by making a fixed annual payment to each employee’s account from the firm, regardless of the year’s revenues and profitability. Employees could be obliged to put aside a certain amount of their pay. Government organizations, public schools, and nonprofit organizations can participate in 401(a) plans, which are money purchase plans. 

Employee stock ownership plans (ESOPs): Shares of an employer’s stock are used to fund these schemes.

Contribution Caps for Defined Contribution Plans

All defined contribution plans are built around contributions. Here are the annual contribution caps for employers and employees for 2022:

TSPs, 401(k), 403(b) and most 457(b) plans. Participants in the scheme may make annual contributions of up to $20,500 in 2022 ($22,500 in 2023) if they are under 50. A further $6,500 can be contributed by those over 50 (rising to $7,500 in 2023). A worker’s combined employer and employee payments cannot exceed $61,000 ($66,000 in 2023), or $67,500 ($73,500 in 2023) if they are 50 years of age or older. Employers may contribute up to 25% of a worker’s salary. 

Profit-sharing plans: Employers may contribute up to the lesser of $61,000 ($66,000 in 2023) or 25% of the employee’s base pay.

Money purchase plans/401(a) plans: Employers and employees may each contribute a maximum of $61,000 ($66,000 in 2023) or 25% of the employee’s net salary, whichever is smaller. 

SIMPLE plans. Employees may contribute up to $14,000 in 2022 ($15,500 in 2023). A further $3,000 ($3,500 in 2023) can be contributed by those who are 50 or older. 

SEP IRAs: Employers may contribute up to the lesser of $61,000 ($66,000 in 2023) or 25% of an employee’s salary to SEP IRAs, which do not allow employee contributions.

Source Disclosure: This article was paraphrased from an article on Forbes and repurposed for educational use. It is designed to encourage people to seek professional financial advice through our short Finance Quiz. Click below to access the original article.

https://www.forbes.com/advisor/retirement/defined-contribution-plan/

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