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Defined Contribution Plan

A Defined Contribution Plan is a type of 401k retirement plan in which an employer, employee, or both make contributions on a regular basis. In most cases, an employee will elect to have a portion of their salary paid directly into the plan. These contributions are typically invested on the employee’s behalf, allowing the account to potentially grow over time through investment earnings.

Here’s how it works in the context of a 401(k) plan:

  • Employee Contributions: Employees can decide to defer a portion of their pre-tax salary to the 401(k) plan. Some plans also allow after-tax contributions in the form of a Roth 401(k).
  • Employer Contributions: Employers can choose to make contributions to their employees’ plans. These can come in the form of matching contributions (where the employer contributes a certain amount based on the employee’s contribution) or non-elective contributions (where the employer contributes regardless of the employee’s participation).
  • Investment Control: The employee often has the ability to choose from a selection of investment options within the plan, which typically include stock and bond mutual funds, target-date funds, and sometimes company stock.
  • Tax Advantages: The contributions made by employees reduce their taxable income for the year they are made. The investments grow tax-deferred, which means that taxes aren’t paid on the earnings until the funds are withdrawn, usually during retirement.
  • Withdrawals: Funds can typically be withdrawn from the plan upon reaching age 59½, though early withdrawals can be subject to penalties. Required minimum distributions (RMDs) must generally start at age 72.
  • Portability: These plans are often portable, meaning that if an employee leaves their job, they can roll over their 401(k) into another plan or an individual retirement account (IRA).

Defined Contribution Plans are different from Defined Benefit Plans, which promise a specific income in retirement and are often referred to as pension plans. In a Defined Contribution Plan, the amount available in retirement depends on the contributions made and the performance of the investments.