Legal Definitions - defined contribution plan

A defined contribution plan is a type of retirement savings account where both the employee and sometimes their employer regularly contribute money. These contributions are then invested in various assets, such as stocks, bonds, or mutual funds. The amount of money an employee receives in retirement depends entirely on how well these investments perform over time. Unlike a traditional pension, the employee, not the employer, typically bears the investment risk.

The primary benefit of a defined contribution plan is that investment gains are not taxed until the money is withdrawn, usually in retirement. However, withdrawals before age 59 ½ often incur penalties, encouraging long-term savings.

• Example 1: Corporate Employee's 401(k)

  Imagine David works for a large software company. Each pay period, a portion of his salary is automatically deducted and deposited into his 401(k) account. His company also contributes an additional amount, matching a percentage of what David puts in. David chooses to invest his 401(k) funds in a diversified portfolio of mutual funds. Over the years, the value of his account grows or shrinks based on the performance of these investments. When David retires, the total amount he has available to live on will be the sum of all contributions plus any investment gains, minus any losses and fees.

  This illustrates a defined contribution plan because both David and his employer contribute to a specific account, and the ultimate retirement benefit he receives is directly tied to the success of his chosen investments, not a guaranteed amount from his employer.

• Example 2: Non-Profit Worker's 403(b)

  Consider Emily, who works as an administrator for a charitable foundation. She participates in a 403(b) plan, which is a retirement savings plan similar to a 401(k) but designed for employees of non-profit organizations and public schools. Emily decides to contribute a fixed percentage of her paycheck to her 403(b) account, which she then allocates among various investment options offered by the plan administrator. The foundation does not offer a matching contribution, but Emily appreciates the tax-deferred growth. When Emily eventually retires, the size of her retirement nest egg will depend on how her investments have performed over her career.

  This example demonstrates a defined contribution plan as Emily's retirement savings grow through her own regular contributions and the performance of her chosen investments. The foundation does not promise a specific payout amount; instead, Emily's retirement income is "defined" by the contributions made and the investment returns achieved.

• Example 3: Self-Employed Individual's SEP IRA

  Michael is a self-employed consultant running his own business. To save for retirement, he sets up a Simplified Employee Pension (SEP) IRA. Each year, he contributes a percentage of his self-employment income directly into this account. Michael then decides which mutual funds and exchange-traded funds (ETFs) to invest his SEP IRA money in. He understands that the value of his retirement fund will fluctuate with the market. When he decides to stop working, the total amount available for his retirement will be the sum of his contributions and the investment returns he earned over the years.

  This scenario highlights a defined contribution plan because Michael, as the sole contributor, funds his own retirement account, and the ultimate value of his retirement savings is determined by the performance of his investments, not by a fixed benefit promised by an employer.