Financial Planning and Analysis

What Is a Defined Contribution Plan?

Learn how a defined contribution plan functions as an individual retirement account, where the final benefit is shaped by contributions and investment performance.

A defined contribution plan is a retirement savings vehicle offered by an employer that focuses on contributions to an employee’s individual account. Unlike a pension, the final amount available at retirement is not guaranteed. It depends on the total contributions from both the employee and employer, plus the performance of the investments chosen within the account. This structure places the primary responsibility for growing the retirement funds on the employee.

Core Mechanics of Defined Contribution Plans

A defined contribution plan operates through individual accounts for each employee. When an employee enrolls, a portion of their paycheck is directed into this personal account. The employer’s obligation is fulfilled by making specified contributions, which transfers the investment risk to the employee. The employee is responsible for how the funds are invested, and the account’s value will fluctuate with market performance.

This structure differs from traditional pensions, or defined benefit plans. In a defined benefit plan, the employer guarantees a specific income for life upon retirement. The employer manages a pooled fund and is responsible for ensuring it has sufficient assets to meet its obligations, regardless of market conditions.

Common Types of Defined Contribution Plans

Several types of defined contribution plans exist, each tailored to different kinds of employers.

  • 401(k): Primarily offered by for-profit companies, this is the most widely recognized plan. Employees contribute a portion of their salary before taxes, lowering their current taxable income, and many employers offer to match contributions.
  • 403(b): This plan serves employees of public schools, certain non-profit organizations, and government entities, functioning similarly to a 401(k) with pre-tax contributions and tax-deferred growth.
  • Thrift Savings Plan (TSP): Available to federal government employees and military members, the TSP is known for its low administrative fees and offers a selection of individual and lifecycle funds.
  • Simplified Employee Pension (SEP) IRA: This plan allows employers to make contributions for themselves and their employees, but only the employer can contribute.
  • Savings Incentive Match Plan for Employees (SIMPLE) IRA: Designed for small businesses, this plan requires employers to make either matching or non-elective contributions.

Contribution Rules and Limits

Contributions to a defined contribution plan come from the employee and the employer. Employee contributions, known as elective deferrals, are amounts an individual chooses to have withheld from their paycheck. These can be made on a pre-tax basis, reducing current taxable income, or as a Roth contribution with after-tax dollars for tax-free withdrawals in retirement.

Employer contributions are a significant feature of these plans. The most common form is a matching contribution, where the employer contributes based on what the employee saves. A common formula is the employer matching 50 cents for every dollar an employee contributes, up to 6% of their salary. Some employers also make non-elective contributions to all eligible employee accounts, regardless of whether the employee contributes.

The Internal Revenue Service (IRS) sets annual contribution limits. For 2025, employees can contribute up to $23,500 to a 401(k) or 403(b) plan. To help workers save more as they near retirement, the law allows for catch-up contributions. Individuals age 50 and over can contribute an additional $7,500.

A provision for 2025 allows those aged 60, 61, 62, and 63 to make a higher catch-up contribution of $11,250. The total amount that can be contributed to an account from all sources—employee, employer match, and other employer payments—is capped at $70,000 for the year.

Investment and Account Management

Once funds are deposited into a defined contribution account, the employee is responsible for directing how the money is invested. Plan administrators provide a menu of investment options, which includes a variety of mutual funds spanning different asset classes like stocks and bonds. Many plans also offer target-date funds, which automatically reallocate their investment mix to become more conservative as the target retirement date approaches.

A vesting schedule determines when an employee gains full ownership of employer-contributed funds. Federal law sets maximum time limits for these schedules. Under a “cliff” schedule, an employer can require up to three years of service before an employee is 100% vested. Any contributions an employee makes are always 100% vested immediately.

With a “graded” schedule, vesting must occur incrementally, with an employee gaining at least 20% ownership after their second year and becoming fully vested after no more than six years of service. For SEP and SIMPLE IRA plans, all employer contributions are also immediately 100% vested.

When an employee leaves their job, they must decide what to do with the vested funds in their account. A common action is a rollover, which involves moving the money from the former employer’s plan into another retirement account, such as an Individual Retirement Account (IRA) or the new employer’s plan. This allows the funds to continue growing in a tax-advantaged environment.

Previous

What Is an Employer-Sponsored Tax-Sheltered Retirement Plan?

Back to Financial Planning and Analysis
Next

How Old Do You Have to Be to Open an IRA?