Today, only 21% of workers participate in a pension plan—depending on whose head count you’re looking at. Aside from 401(k) and 403(b) plans, two other common types of defined contribution plans are profit-sharing and employee stock ownership plans. These plans, which include traditional pensions and cash-balance plans, provide a guaranteed payout upon retirement, which is usually based on a preset formula. Defined-benefit plans and defined-contribution plans are two retirement savings options.

One major disadvantage of defined contribution plans is that they do not guarantee a specific retirement income. Investment choices and decisions regarding contributions determine the success or failure of these types of accounts. Then you decide how much of each paycheck you’d like to contribute to the plan. It could be a set dollar amount or a percentage of your salary, and you can change your contribution rate at any time. Your employer automatically is interest on a home equity line of credit withholds this amount from your paycheck and places it in your defined contribution plan. Employees can contribute up to $22,500 to their account in 2023, or $30,000 if they’re 50 or older.

Therefore, those unsatisfied with their defined contribution plan might supplement it with an IRA, which offers additional options and flexibility. You may be able to choose between a traditional or Roth version of the retirement plan your employer offers. Of course, you can always use a lump-sum distribution to purchase an immediate annuity on your own, which could provide a monthly income stream, including inflation protection. As an individual purchaser, however, your income stream will probably not be as large as it would with an annuity from your original defined-benefit pension fund. When a defined-benefit plan is made up of pooled contributions from employers, unions, or other organizations, it is commonly referred to as a pension fund.

What Is a Pension? Types of Plans and Taxation

1. The 457 plans are tax-advantaged retirement plans similar to 401(k)s offered by state and local governments and specific tax-exempt organizations.
2. While they are rare in the private sector, defined-benefit pension plans are still somewhat common in the public sector—in particular, with government jobs.
3. A lump-sum distribution may or may not be an option, but if it is, you may be able to roll that money into a new employer plan or an IRA.
4. If your company offers an employer match, be sure to take advantage of it.
5. There may be a waiting period before any contributions your employer makes to the account become yours to keep, this is often called a “vesting” period.
6. This type of retirement plan lets employers share the wealth with employees.

Since 1999, we’ve been a leading provider of financial technology, and our clients turn to us for the solutions they need when planning for their most important goals. Opting to take defined payments that pay out until death is the more popular choice, as you will not need to manage a large amount of money, and you’re less susceptible to market volatility. 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.

What are the types of defined contribution plans?

Online financial calculators can help you make the decision of whether to take a lump sum versus annuity distributions. You can combine a SEP IRA with a defined-benefit plan, depending on whether or not the SEP is a model SEP or a non-model SEP. The type of SEP is determined by the filing of IRS Form 5305, and you would need to confirm which type of SEP you have with your SEP custodian. Plan participants under 50 can contribute up to $22,500 a year to a 401(k) in 2023 and up to $7,500 in catch-up contributions if they are over age 50.

How Is a Defined Contribution Plan Different From a Defined Benefit Plan?

With defined contribution plans, the employee controls how much money to contribute and where that money is invested. It is up to them to actively manage their investments and ensure enough funds are available for retirement. More ubiquitous in recent decades is the defined-contribution plan, such as a 401(k) plan. With these plans, employees are responsible for saving and investing for their retirement years.

You may be hit with a 10% penalty on top of any income tax you may owe if you make a withdrawal before then. 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. The articles and average revenue per user research support materials available on this site are educational and are not intended to be investment or tax advice.

& 2024 contribution limits

Some companies are keeping their traditional defined-benefit plans but are freezing the benefits. This means that after a certain point, workers will no longer accrue greater payments, no matter how long they work for the company or how large their salary grows. Contributions that employees make to the plan come off of the top of their paychecks—that is, they’re taken out of an employee’s gross income. That effectively reduces the employee’s taxable income, and the amount they owe to the IRS come tax day.

If John’s employer offered a defined-benefit plan, his employer would fund the pension itself, perhaps with some extra contributions from John. It would then give the pension money to an outside investment firm to manage or invest the funds itself. John has no say in what the company invests in, and he has to trust that they will be able to make their payouts from the plan come retirement.

Employers have steadily moved away from defined benefit plans because of the liability attached to them. Under defined benefit plans, the company carries the risk and must invest funds to pay out a pension indefinitely to employees. Under a defined contribution plan, the risk is transferred to the employee, who then must make smart investments. A defined contribution plan is a tax-deferred retirement plan in which employees contribute a set amount or a percentage of their income to a retirement account. Such investments grow tax-deferred, meaning no taxes are paid until the money is withdrawn. Defined-benefit pension plans involve an employer guaranteeing a specific retirement payment if an employee works for a company for a designated amount of time.

However, some employers require employees to remain at the company for years before they gain full ownership of employer contributions. Employees must become informed about their primary plan’s vesting rules. In that case, maximizing employer-matching contributions, and then moving the rest of your retirement contributions into an IRA makes the most financial sense. The amount you have when you enter into retirement will vary based on your contribution amounts, investment choices and the market’s behavior. This type of retirement plan lets employers share the wealth with employees. If you decide to leave the company, you may take your 401(k) with you, rolling it over into your new employer-sponsored retirement plan or into an IRA you open on your own.

Reducing your RMDs by rolling them into a Roth IRA or purchasing a qualified longevity annuity contract (QLAC) may be possible. Defined contribution plans such as 401(k)s offer several advantages that can make saving for retirement more accessible and more efficient. There are several things to consider when choosing between a monthly annuity and a lump-sum payment. If you do not pay back the loan, the funds are considered a distribution, and you’re required to pay the penalty and tax.

However, the investment menu can also include annuities and individual stocks. Examples of defined contribution plans include 401(k)s, 403(b)s, 457s, IRAs, and profit-sharing plans. Each plan has different features to meet the individual needs of employers and employees. These plans carry risks and the potential for less retirement income than traditionally defined benefit plans. But you may find comfort in directly managing where and how much you choose to invest when setting up the plan.

What are the benefits of a defined contribution plan?

A pension plan is an employee benefit that commits the employer to making regular contributions to a pool of money set aside to fund payments to eligible employees after they retire. These may include pretax contributions that reduce an employee’s taxable income—plus potential tax-write offs for the employer. Alternatively, plans can allow post-tax Roth contributions, which can give an employee tax-free income in retirement. A defined contribution plan is sponsored by an employer, which typically offers the plan to its employees as a major part of their job benefits. While they are rare in the private sector, defined-benefit pension plans are still somewhat common in the public sector—in particular, with government jobs. DC plans take pre-tax dollars and allow them to grow capital market investments tax-deferred.

A defined contribution plan is an employer-sponsored retirement plan funded by money from employers and employees. The money you save for retirement in a defined contribution plan is invested in the stock market, and you may also get valuable tax breaks when you make contributions. The government imposes restrictions on how much you can contribute to a defined contribution plan and when you can withdraw your funds.