What Is a Defined Contribution (DC) Plan?

What Is a Defined Contribution (DC) Plan?

Let me explain what a defined contribution (DC) plan is—it's a retirement savings plan where you, as an employee, contribute a fixed amount or a percentage of your paycheck to an account designed to fund your retirement. These plans are typically tax-deferred, like a 401(k) or 403(b), and your employer might match a portion of your contributions as an extra benefit. Remember, there's no promise of a specific benefit amount, and there are restrictions on when and how you can withdraw funds without penalties.

Understanding Defined Contribution (DC) Plans

You can't predict exactly how much a DC plan will provide upon retirement because contribution levels can change, and investment returns fluctuate over time. As of December 31, 2023, DC plans held $10.6 trillion out of $38.4 trillion in total U.S. retirement assets, according to the Investment Company Institute. These plans differ from defined benefit (DB) plans, which guarantee a specific benefit at a future date.

In a DC plan, you contribute pre-tax dollars that grow through capital market investments on a tax-deferred basis. You'll pay income tax on withdrawals, but only at retirement age—starting at a minimum of 59½, with required minimum distributions beginning at age 73. The strategy assumes you'll be in a lower tax bracket in retirement than during your working years, and earnings inside the account aren't taxed until withdrawn. If you pull money out before 59½, expect a 10% penalty unless you meet exceptions.

Advantages of Participating in a DC Plan

Contributions to a DC plan are often tax-deferred until you make withdrawals. With a Roth 401(k), you contribute after taxes, but qualified withdrawals are tax-free. This tax-advantaged setup usually lets balances grow larger than in taxable accounts like brokerage investments.

On March 29, 2022, the U.S. House passed the Securing a Strong Retirement Act of 2022, known as Secure Act 2.0, to help build retirement funds through DC plans. It includes mandatory automatic enrollment, a later RMD start age, higher catch-up contributions, and allowances for matching contributions in Roth 401(k)s and on student loans.

Your employer might provide matching contributions—commonly $0.50 per $1 you contribute up to a certain percentage, or even dollar-for-dollar up to 4% to 6% of your salary. If your employer matches, contribute at least the maximum they'll match; it's essentially free money that grows over time for your retirement. Other features include automatic enrollment, contribution increases, hardship withdrawals, loans, and catch-up options for those 50 and older.

Limitations of DC Plans

In a DC plan like a 401(k), you must invest and manage your own money to build retirement income. Not everyone is financially savvy or experienced with stocks, bonds, or other assets, which can lead to poorly managed portfolios—such as over-investing in your company's stock instead of diversifying across asset classes.

Unlike professionally managed DB pensions that guarantee lifelong income as an annuity, DC plans offer no guarantees. Many workers, even with diversified portfolios, don't save enough and end up short on retirement funds. Vanguard's 2024 study shows the average American retirement savings at $134,128 across ages, but the median is only $35,286, skewed by a few high savers.

DC Plan Examples

The 401(k) is the most well-known DC plan, available to employees of public companies. The 403(b) is for nonprofit employees, like those in schools. The 457 plan serves certain nonprofits and state or municipal workers. Federal employees use the Thrift Savings Plan (TSP), and 529 plans fund college education. Individual retirement accounts (IRAs) can also count as DC plans since they involve tax-advantaged contributions without guaranteed benefits.

How Is a Defined Contribution Plan Different From a Defined Benefit Plan?

A DB plan guarantees retirement income from your employer, calculated by factors like employment length and salary history. DC plans have no guarantees, don't require employer funding, and are self-directed.

Can I Cash Out My Defined Contribution Pension Plan?

You generally need to keep money in the plan until age 59½. Withdrawing earlier could mean a 10% penalty plus income taxes.

Can You Withdraw Money From a Defined Contribution Plan?

Yes, but understand the rules and tax implications first.

The Bottom Line

Defined contribution plans are retirement options where you, your employer, or both contribute specified amounts regularly. Common ones include 401(k), 457, and 403(b) plans. You choose investments to match your goals, from high-risk, high-return options to conservative ones. Unlike DB plans, they don't guarantee income, which can leave some with insufficient savings.