How do workplace retirement plans differ?
In a defined contribution plan, both you and your employer can contribute to your individual account. There may be a waiting period before any contributions your employer makes to the account become yours to keep, this is often called a “vesting” period.
In a defined benefit plan, generally your employer makes all the contributions. In addition, pensions generally require a specific number of years of service before the benefits become yours to keep.
Typically, both defined benefit and defined contribution plans automatically enroll participants, and some plans may have enrollment waiting periods.
How do defined contribution plans work?
As an employee, you decide how much you want to contribute to your individual account. Your contributions are deducted from your paycheck and added to your account automatically. Your employer may offer matching contributions, here’s how they work: If you contribute a dollar, your employer may add a portion of a dollar in return, up to a certain percentage of your salary (usually 3-6%, though these percentages vary based on employer policy).
For 2024, the maximum amount an employee can contribute to a 401(k) plan is $23,000 per year. If you are age 50 or older, you can add what’s known as a catch-up contribution of up to an additional $7,500, for a total of $30,500 per year. The IRS sets annual maximum contribution limits for various plans.
After you decide how much to contribute, you also choose how to invest your money. Most plans offer several investment choices, and each has its own fee structure and risk profile.
Defined contribution plans offer a tax-advantaged way to save for retirement. For example, in a 401(k) plan, your contributions are made with pre-tax dollars, and along with any earnings your contributions produce are tax-deferred until you withdraw the money.
Eventually, you’ll need to consider how you’d like to withdraw from your account. You can start withdrawing funds, penalty-free, after age 59½. Be careful – if you withdraw before then, you could face a 10% early withdrawal penalty and owe income tax on the amount you take out. There are some exceptions to this rule.
