Defined Contribution Plans
A defined contribution plan is an investment vehicle that allows employees to save money for their retirement.
The basic premise of a defined contribution plan is that a fixed or defined amount of money is contributed by the employee and sometimes the employer into an investment vehicle with various investment options that will earn interest over the lifetime of an employees career. These earnings and continued employee/employer contributions from the employee, and possibly the employer, will usually grow large enough over time to provide an income basis for the employee when he or she is ready to retire.
Unlike a defined benefit plan, defined contribution plans do not guarantee a specific benefit amount to be paid at retirement. When an employee is ready to retire, he or she is able to withdraw the money that has accumulated in his or her defined contribution account. The value of that account depends on how much has been invested and interest rate earned (rate of return) on the investments within that account.
Employee provides the contributions to the plan from their own pay. The benefit of a defined contribution plan to the employee is the tax break they get for contributing. There are also special tax benefits an employee receives from the U.S. government if he or she contributes to a defined contribution plan to save for retirement.
Some employers also contribute to employees defined contribution accounts. For example, in a plan with a profit sharing contribution the company may contribute a certain amount at the end of a fiscal year if earning is strong for the company. Some companies also provide a matching contribution to help grow the employees defined contribution plan balance. For example, an employer may put in 50 cents for each dollar the employee contributes, up to a certain annual limit.
Employees typically have a choice as to how much they contribute to a defined contribution plan. They also usually have a choice about how to invest account balance. A defined contribution plan usually offers three or more investment options.
There are various types of defined contribution plans regulated by U.S. tax laws. The names of various defined contribution plans often refer to U.S. tax law code sections that explain the tax rules for the respective plan. For example, the most common U.S. defined contribution plan, the 401(k) plan, has provisions specified in section 401(k) of the U.S. Internal Revenue Service Code. Other defined contribution plans include the 403(b) and 457 plans. These plans have unique provisions for participation and tax exemption, according to U.S. tax laws.