What are defined contribution retirement plans?
Think savings accounts with tax benefits—and a lot of rules.
Tax-deferred defined contribution plans include the familiar 401(k) plans, similar 403(b) plans for nonprofit employees, 457 plans (mostly for state and local government employees), and the federal government’s Thrift Savings Plan.
Less than 40 percent of workers contributed to a defined-contribution plan in 2014. Workers’ participation in defined contribution plans generally increases with age and income. About three-quarters of workers earning $100,000 or more made contributions (table 1).
Contributions and Withdrawals
Contributions to defined contribution plans are tax deferred, meaning that neither the employer nor the employee pays tax on initial contributions or accumulating plan earnings. However, employees pay tax when they withdraw funds. The major exception is Roth-type defined-contribution plans. With Roth plans, account holders pay taxes when contributions are made rather than when contributions are withdrawn.
Early withdrawals from defined-contribution plans incur penalties (in addition to the regular tax on withdrawals), except for specified purposes such as financial hardship, higher education, or the first purchase of a home.
Defined benefit plans offer employees a contractually assured annuity at retirement. In contrast, under a defined contribution plan, an employee owns an account in which balances depend on the size of past contributions and on the investment returns those contributions accumulate. The employee bears the risk of underperforming assets and the possibility of outliving the income generated. But employees can manage these risks at retirement by using the assets in their plans to purchase annuities from insurance companies.
Internal Revenue Service. SOI Tax Stats—Individual Information Return Form W-2 Statistics. Table 3.A. “Taxpayers with Wage Income, by Size of Wage Income, Presence of Retirement Plan Indicator, and Elective Retirement Contributions, Tax Year 2014”; Table 3.C. “Taxpayers with Wage Income, by Age of Taxpayer, Presence of Retirement Plan Indicator, and Elective Retirement Contributions, Tax Year 2014”; and Table 3.D. “Taxpayers with Wage Income, by Return and Earner Type, Presence of Retirement Plan Indicator, Elective Retirement Contributions, Tax Year 2014.”
Burman, Leonard E., William G. Gale, Matthew Hall, and Peter R. Orszag. 2004. “Distributional Effects of Defined Contribution Plans and Individual Retirement Accounts.” Discussion Paper 16. Washington, DC: Urban-Brookings Tax Policy Center.
Congressional Budget Office. 2007. “Utilization of Tax Incentives for Retirement Saving: Update to 2003.” Washington, DC: Congressional Budget Office.
Employee Benefit Research Institute. 2015. “Chapter 5.” In EBRI Databook on Employee Benefits. Washington, DC: Employee Benefit Research Institute.
Kawachi, Janette, Karen E. Smith, and Eric J. Toder. 2006. “Making Maximum Use of Tax-Deferred Retirement Accounts.” Washington, DC: Urban Institute.
Orszag, Peter R. 2004. “Balances in Defined Contribution Plans and IRAs.” Tax Notes 102 (5): 655.
Purcell, Patrick. 2007. “Pension Sponsorship and Participation: Summary of Recent Trends.” Washington, DC: Congressional Research Service.