What is a Defined Contribution Plan?

In general, a defined contribution plan is a tax-deferred savings plan that people fund with their own money (rather than an employer) and use to save for retirement. It is the opposite of a defined benefit plan, which is typically a pension plan funded by the employer or an entity other than the person who will directly benefit from the plan.

How Does a Defined Contribution Plan Work?

A 401(k) plan is the most common type of defined contribution plan, though there are other types of similar plans for certain types of employees. For example, self-employed people might open a Keogh plan, or public employees might join a 403(b) plan.

The idea is the same, though: employees contribute a portion of their pay on a pre-tax basis in their own accounts. Employees choose how much they want to save per year, up to the maximum allowed by the plan. In many cases, employers will match employee contributions up to a specified percentage and, in some cases, employers may offer additional contributions as part of an incentive package.

The defined contribution plan then invests the funds in a securities portfolio. The composition of the portfolio may vary depending on how the company manages its plan and the level of risk with which the employee is comfortable. In most cases, employees may choose from a variety of portfolio allocations.

At retirement age, the employee can begin withdrawing the funds. Should the employee choose or need to withdraw funds prior to retirement age, he may incur certain penalties specified in the plan.

Why Does a Defined Contribution Plan Matter?

A defined contribution plan gives employees the opportunity to invest their money in the securities markets for the purpose of setting money aside for retirement without the burden of taxation. In addition, the plan's withdrawal restrictions serve as an incentive for employees not to use the funds and allow them to grow as much as possible.