Defined Contribution Plan: U.S Private Industry Pensions are based upon the Employee Retirement Income Security Act of 1974 (ERISA), which is administered by the Department of Labor through the Employee Benefits Security Administration. There is a federal law that sets minimum standards for most voluntarily established retirement and health plans in the private industry to provide protection for individuals in these plans.
There are mainly two types of pension plans – the defined-benefit plan and the defined contribution plans.
In this article, we herby discuss only on Defined-Contribution Plan. You may love to read a detailed comparison between Defined Contribution and Benefits plan.
What is a defined contribution plan?
In retirement planning, you must hear about a number of savings plans – 401(k), 457, or even 403(b) but what do these numbers mean and how do they differ from each other?
A Defined Contribution Plan (DCP) is a retirement pension plan against which an employer has made a definite annual contribution but does not guarantee to the employee, as a result of the outcome of these benefits. The employee’s benefits are calculated projected – a sum of the amount contributed plus the investment income.
This Defined Contribution Plan is also known typically tax-deferred, such as a 401(k) or a 403(b), in which an employee contributes a fixed amount or a percentage of their salary in the fund manager like equity funds, mutual funds, company stock, money-market equivalents or fixed-rate options. The sponsor company will match a part of employee contributions as an added benefit in the relevant fund manager. These type of plans comes with different terms and conditions that how an employee can withdraw funds from these accounts without any penalty.
Types of Defined Contribution Plans
There are many types of Defined Contribution Retirement Plans against which employers provide many benefits to their employees – the most common is the 401K but maybe some other similar plans also of the defined contribution, family include 403(b)s, 457s, and Thrift Savings Plans.
MAIN POINTS ABOUT DEFINED CONTRIBUTION PLAN
- Both Defined Contribution Plans (DCP)- 401(k) and 403(b) are generally used by companies OR organizations to motivate their employees to save money for retirement.
- Defined-contribution (DC) retirement plans also permit an employee to invest pre-tax dollars in the capital markets where their investment can grow in order to tax-deferred until retirement.
- In a comparison of Defined Contribution plans with defined-benefit Plans, the Defined-Benefit Plan is beneficial as in which retirement income is guaranteed by an employer. Under Direct Contribution Plan, there are no guarantees, and participation of both sides is voluntary and self-directed.
Understanding of Tax-DeferredTax-deferred means earnings on investment- such as interest, dividends or capital gains, etc. which makes the accumulated corpus tax-free till the investor do not take constructive receipt of the profits. There are some similar examples of tax-deferred investments which include individual retirement accounts (IRAs) and deferred annuities. - Tax-deferred status means earnings on investment -such as interest, dividends or capital gains, etc. which makes the accumulated corpus tax-free till investors do not take constructive receipt of the profits.
- An investor can take the benefits of the tax-free growth through the earnings with tax-deferred investments. Such type of investments which held up to retirement generates tax savings in substantial quantity.
- A similar example of a tax-deferred investment plan is the 401(k) plan and 403(b) plan which are tax-qualified defined contribution plans, generally, offered by employers to help grow employee’s retirement savings more significantly.
What Is a 401(k) Plan?
A 401(k) plan is a tax-deferred, defined-contribution retirement plan, which is offered by many employers to their employees. Under this Defined-Contribution Plan, workers can make contributions to their 401(k) accounts through an automatic payroll withholding and their employers can also match some or all of those contributions, as mutually agreed by the employer and employee.
How 401(k) Plans Work?
There are two basic types of 401(k) accounts – Traditional 401(k)s and Roth 401(k)s. Both these accounts are similar in many respects but they are taxed in different ways.
The investment earnings under the 401(k) plan are not taxed until the employee does not withdraw that money, typically after retirement OR in extraordinary circumstances. In a Roth 401(k) plan, withdrawals can be tax-free. A worker can have either type of account or both types.
Facts about 401(k) Plan
401(k) plan is a tax-qualified defined contribution account that is generally offered by employers to its employees in order to grow employees’ retirement savings moe significantly. Companies or Organizations appoint a third-party administrator (TPA) to manage contributions, which are deducted from employee salary. Employees can choose among these various options – like equity funds, company stock, money-market equivalents, or fixed-rate options in order to invest their contributions as per their own will. Contributions in savings plans, like 401(k) accounts, are made on a pre-tax basis, reducing taxable income received by the employee, which generally lowers the tax liability.
- Under DCP – 401(k) is a company-sponsored retirement account in which employees can contribute and employers can also make matching contributions.
- There are two types of 401(k)s accounts —Traditional and Roth—which differ primarily in how they are taxed.
- Under traditional 401(k), employee contributions decrease tax for the year they have to take in during the year but any withdrawals are taxed. With a Roth plan, employees make contributions with post-tax income but can make withdrawals tax-free.
- Employees are also responsible to choose specific investments within their 401(k) accounts, from the selection their employer offers. Those offerings generally include an assortment of stock and bond mutual funds as well as target-date funds that hold a mixture of stocks and bonds deem fit in terms of risk for when that person expects to retire. They may also include guaranteed investment contracts(GLCs) issued by insurance companies and sometimes the employer’s own stock.
- For 2020, under the CARES Act, withdrawal rules and amounts were relaxed for those persons who were getting infected by COVID-19.
Contribution LimitsThe maximum amount that an employee OR an employer can contribute under the 401(k) plan is adjusted periodically subject to the rate of inflation. As of 2020 and in 2021, the basic limits on employee contributions are $19,500 per year for workers under age 50 and above age 50 OR more – $26,000 (including the $6500 catch-up contribution).In case, if the employer also contributes OR if the employee wants to make an additional contribution, non-deductible after-tax contributions to their traditional 401(k) account (if terms and conditions of the plans allow)—the total employee/employer contribution for workers under 50 years of age for 2021 is capped at $58,00o or 100% of employee compensation, whichever is lower. For those 50 years of age and above for 2021, the limit is $64,500.Employer Matching Vs. Employee Matching in contributionEmployers who intend to match with their employee contributions generally use different formulas to calculate that matching. A common example may be i.e 50 cents or $1 for every dollar, the employee contributes up to a certain percentage of salary. Financial advisors also advise that employees should try to contribute at least enough money to their 401(k) plans so that each to get the full employer contribution in consolidating way.Contributing to a Traditional and Roth 401(k)In Case, if the employers offer both choices in investments – traditional and Roth 401(k), the employee can also split their contributions and invest some money into a traditional 401(k) and some in Roth 401k). However, the total contribution of both these accounts cannot exceed the limit for one account, such as $19,500 (if you are under age 50) in 2020 and 2021Withdrawals Rules from a 401(k)Participants should not forget that if they want to withdraw money under 401(k), it may be very hard without any penalty. Hence it is advisable not to put all of your saving into 401(k) where you cannot easily withdraw the money, whenever you need in case of emergencies, as nobody know when you have t to face trouble in life.Now you must have understood that the earnings under 401(k) account are tax-deferred only and tax-free in the case of Roths. When the participant of a traditional 401(k) makes withdrawals, that money (which has never been taxed) will be taxed as ordinary income but Roth account participants (who have already paid income tax on the money they contributed to the plan) will owe no tax on their withdrawals, as long as they are satisfying the terms and conditions of the government.Both traditional and Roth 401(k) participants must be at least age 59½ of age OR meet the other criteria, implemented by the IRS, like being totally and permanently disabled, when they start money from their account. Otherwise, beyond in general situations, they will have to face an additional burden of 10% early-distribution penalty tax on top of any other tax they owe.Required Minimum Distributions beyond the Specified Age LimitBoth types of accounts require minimum distribution beyond the specified age limit. After attaining the age of 72, account holders are advised to withdraw at least a specified percentage of money from their 401(k) plans by using the IRS tables based on their life expectancy at that time (prior to 2020, the RMD age had been 70½ years old).In case, if the participants are still working with any company or organization, they are not entitled to take RMDs from the plan. Moreover, they also lose the tax-free growth of being within the 401(k) account. FAQsWhat is a 401(k) Plan and how does it work?401(k) Plan is a defined-contribution retirement account which permits employees to save some part of their salary for tax savings. . The money earned in a 401(k) Plan will not attract tax until the employee does not retire and their income should be e lower than during their working years. 401(k) Plans also permit employers to match a part of the contributions made by the employee, helping to grow their retirement funds quickly.Is it worth having a 401(k) plan?401(k) plan is beneficial for those employees who want to save money for their retirement and also intend to get the tax-deferred benefits. Moreover, a 401(k) plan can be the best option subject to depend on the employee’s determination of choosing the best fund manager and participation in an equal matching program by the employer.