Savings and Retirement: What are defined-contribution retirement plans?
A defined-contribution plan is a plan in which an employee’s benefits during retirement depend on the contributions made to and the investment performance of the assets in his or her account, rather than on the employee’s years of service or earnings history. Like a typical savings account, a defined-contribution account contains a specific balance at any given time, which is equal to the market value of the assets accumulated in the account. Unlike with a defined-benefit plan, employees have substantial control over how the contributions to their plan are invested and may generally choose from an assortment of stocks (often including company stock), bonds, mutual funds, and other investment vehicles. Examples of defined-contribution plans include 401(k) plans, 403(b) plans, and 457 plans, all of which share similar characteristics.
- The proportion of employees participating in defined-contribution plans has gradually increased over the past several decades, and today stands at about half of all workers nationwide. However, within the defined-contribution universe, savings and
thrift-type plans have grown in popularity at the expense of profit-sharing plans.
- Compared with defined-benefit plans, which offer employees an annuity at retirement, defined-contribution plans are riskier for employees, because the employee bears the risk of underperforming assets and extended longevity. This risk can be muted if employees use the assets in their defined-contribution plan to purchase annuities at retirement.
- Contributions to defined-contribution plans are tax-deferred, meaning that neither the employer nor the employee pays tax on the initial contributions or accumulated earnings. However, the employee does pay tax when funds are withdrawn. Exceptions to this rule are Roth 401(k) plans, which tax contributions when they are made rather than when the contributions are withdrawn.
- Withdrawals from defined-contribution accounts are generally not permitted before age 59 except in certain circumstances, such as the purchase of a first home or the payment of certain educational or medical expenses. In these circumstances, tax penalties may reduce the value of the account.