These days, more organizations are leaning into DC plans as a flexible and preferred option that yields a more personalized strategy to save for retirement. If you're hoping to take greater responsibility for your financial future, understanding the ins and outs of defined contribution plans is a great place to start.
Overview of Defined Contribution Plans
In a DC plan, both employees and employers contribute funds into individual accounts that are set up for each plan participant. Employee contributions are often made pre-tax which allows for tax-deferred growth, while employers then offer matching contributions to expedite savings.
One key element of a DC plan is your ability as an employee to choose from various investment options, including mutual funds, stocks, exchange-traded funds (ETFs), and more, which then grow over time through investment earnings. This structure places more emphasis on individual responsibility and investment choices as you're the one who commits to making contributions and you choose how those funds are invested. When you retire, it's what's in your account balance that matters.
Types of Defined Contribution Plans
401(k) Plans
A 401(k) plan is a highly popular type of defined contribution retirement savings plan that employers offer their employees. In a 401(k), employees can contribute a portion of their salary on a pre-tax basis allowing them to save for retirement while enjoying tax-deferred growth on their investments until they withdraw funds during retirement. In many cases, employers will match employee contributions to 401(k) accounts.
403(b) Plans (for nonprofit organizations)
A 403(b) plan is similar to a 401(k) in that it allows employees to contribute pre-tax dollars to reduce their taxable income while saving for retirement, but it's designed specifically for public school employees, nonprofit organizations, and some religious institutions. Just as with 401(k) plans, employers can match employee contributions and the funds can grow tax-deferred until withdrawal during retirement.
457(b) Plans (for state and municipal employees)
A 457(b) plan is a tax-advantaged retirement savings plan designed for both state and local government employees and some nonprofit organization employees. A 457(b) plan allows employees to contribute either pre-tax salary earnings or potentially Roth contributions using after-tax funds. Unlike a 401(k), however, 457(b) plans allow employees to make penalty-free withdrawals if they leave their job or retire before the age of 59½.
Thrift Savings Plan (for federal employees)
A Thrift Savings Plan (TSP) is designed for federal employees as well as members of uniformed services and allows employees to make contributions either pre-tax or after-tax (Roth). The federal government provides matching contributions that help employees bolster their retirement savings funds, and there are a number of investment options available for effective fund management.
Contributions to Defined Contribution Plans
Both employers and employees play crucial roles in using DC plans to build retirement savings. Subject to annual contribution limits, employee contributions represent the allocation of a portion of their salary to their retirement account, while employer contributions are done by matching the contributions made by the employee. As you can imagine, this creates a great incentive for you as an employee to contribute more, as your employer will match a percentage of what you allocate. Think of employer matching contributions as essentially free money - if your employer matches 50 cents for every dollar you contribute, you're getting $1.50 in retirement savings for every dollar you personally contribute.
The Internal Revenue Service (IRS) sets annual limits on contributions in order to regulate how much money can be contributed to these plans. For 2025, 401(k) contribution limits are set to $23,500 for employees, while the total of all funds contributed by employee and employer is $70,000For 2024, 401(k) contribution limits are set to $23,000 for employees, while the total of all funds contributed by employee and employer is $69,000. If you're 50 or older, you can also make a catch-up contribution of up to $7,500 (bringing your total contribution amount to $30,500).
Tax Advantages of DC Plans
There are significant tax advantages you can access through a DC plan. Tax-deferred growth is the big one, meaning that your investment earnings grow rapidly over time and aren't taxed until you withdraw them. In some cases, you can also choose to contribute after-tax dollars through Roth options, which means taxes are paid upfront while withdrawals during retirement are tax-free. When you withdraw from pre-tax contributions during your retirement, the funds you take are subject to regular income tax at your ordinary tax rate.
Investment Options within DC Plans
You can choose from a wide selection of investment options to grow your retirement savings within a DC plan. Investment choices include everything from mutual funds and stocks to real estate and commodities, each with their own levels of risks and potential return. Before making your choices you'll want to consider your investment risk tolerance so you can ensure effective investment management and, of course, maximize your retirement funds.
Withdrawals and Accessing Funds
There are rules that govern when and how you can withdraw and access your funds, and a big one is your age. Withdrawals made before you reach the age of 59½ are subject to a 10% early withdrawal penalty in addition to regular income tax, which can significantly reduce the amount you receive.
It's important to note that if you're planning to delay withdrawing funds for as long as possible (past the retirement age of 67, for example), there are required minimum distributions (RMDs) that you must take each year once you turn 73.
Risks Associated with Defined Contribution Plans
Despite being a great investment option for many, DC plans present a level of inherent risk as you are in control of your own investments. This means that market fluctuations and volatility can impact your account balances one way or the other. If you don't consider a diversification strategy, you could end up facing damaging losses. It's also important to consider your longevity risk—you don't want to outlive your savings and run out of cash too soon! Luckily, proactive financial planning and regularly reviewing your investment strategy can help you mitigate these risks and stay on top of options that can provide a regular, steady income throughout your retirement.
Eligibility and Vesting in DC Plans
To participate in a DC plan, you'll often have to meet certain criteria set by your employer. There may be a minimum age or length of service before you can enroll, and this can vary from plan to plan, employer to employer. Once you're eligible for employee benefits, you'll start making contributions to your retirement account and receiving contributions from your employer. But what if you quit or change jobs? You may be entitled to your own contributions right away, but employer contributions work a bit differently. Many employers will have vesting requirements that dictate how many years of service you need to put in before you fully own the amount that they have contributed.
