A defined contribution plan is a retirement plan in which a difference between the amount an employee contributes to the plan, usually through salary withholding and the amount of employer contribution is predetermined in the Plan Document. Defined contribution plans are typically set up as either 401(k)s or 403(b)s and offer a variety of investment options available to the employee.
How Does a Defined Contribution Plan Work?
In a defined contribution plan, the employer’s contributions are typically in the form of employer contributions (matching, non-elective, or after-tax contributions) as well as any performance-based awards, such as stock options and bonuses. Contributions may also come from salary deferral plans or defined benefit plans. The employer can also make contributions to the participant’s account balance, which are capped at a certain annual limit depending on the type of plan.
The employee’s contributions are usually in the form of salary deferrals under a 401(k) or 403(b) plan. Under these plans, the employee elects to defer a portion of their salary each pay period (up to a certain contribution limit) and the amount is deducted from their regular paycheck and allocated to a retirement plan account. The employer may match a portion of the employee’s contributions, up to a certain amount, and over a certain period of time.
Advantages of a Defined Contribution Plan
A defined contribution plan offers a number of advantages for both employers and employees. Since these plans are funded through salary deferrals, the employer does not have to bear the entire cost of the program and can manage their own contributions to the plan. Since the plan investments are managed by the employee, there is also less risk involved; employers do not have to worry about the plan investments and can pass this responsibility to the employee.
For employees, a defined contribution plan offers flexibility in terms of investment options and control over their retirement savings. Employees can decide how much to contribute and can select investments that best align with their retirement goals. Defined contribution plans also allows for tax-deferred growth of retirement savings, as contributions by the employee are typically made with pre-tax dollars.
Conclusion
Defined contribution plans offer employers and employees a number of advantages, including lower costs, flexibility, and tax-deferred growth. For employees, they provide an easy and efficient way to save for retirement while controlling their investments. For employers, they offer a cost-effective way to provide a retirement benefit to their employees.