Introduction to Defined-contribution Retirement Plans

These plans are more common in today's work environment than defined-benefit plans. The reason: these are less costly to employers.

With 401(k) retirement accounts, each employee is responsible for contributions and for selecting investments

The second type of employer-sponsored plans is the defined contribution plan. Under this plan, the retirement income will depend on contribution and performance of holdings in the plan. There is no guarantee of a specific pension amount.

401(k) Retirement Accounts

A common defined-contribution plan in the United States is the 401(k). Here, an employer will match employee’s contributions. The maximum amount allowed per year is $18,000 (based on 2017 limit) with a special catch up provision of $6,000 for employees that are 50 or older.

The amount that is contributed can actually be less as the employer sets a limit (which can’t exceed IRS guidelines) as to how much will be contributed. For instance, the policy may be that employer will match employee’s contribution for the first 5% contributed. So, if employee contributes 5%, there will be a 5% match by employer for a total contribution of 10%. If employee earns, let’s say, $50,000 per year, a total yearly 401(k) contribution will come to $5,000. 

Note that employer contributions are subject to vesting, meaning that if an employee leaves a company before certain period of time is up, a part of employer’s contribution will be taken away. A vesting plan can be based on a period of 5 years with 20% of the amount vested each year.

Effectively, employer contributions of 5 years ago will be fully vested, while those of 4 year ago will be 80% vested, and those of 3 years ago will be 60% vested (and so on until most recent contributions that are 0% vested). This applies only to employer, not employee, contributions. As these vesting periods can differ, always check your employer’s policy.

Standard 401(k) plans are tax-deferred, which means plan contribution money is taken before taxes. Once employee retires, the amount accumulated is subject to tax (which could be lower if a person ends up in a lower tax bracket during retirement, which often is the case).

Roth 401(k) is a new kind of a plan. Under it, employees contribute after taxes but upon retirement these funds aren’t taxed. Also, once a contribution is made, any gains within the plan aren’t taxed.

There is also a plan for non-profit organization workers, 403(b), as well as a plan for government workers, 457(b).

These defined-contribution plans come in addition to social security payouts. Early withdrawals from 401(k) are possible but these incur a tax penalty. It is also possible to borrow from your own 401(k) plan.

Funds can be withdrawn without a tax penalty at the age of 59 ½, and no later than at the age of 70 ½.

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