A defined contribution plan is a type of retirement savings plan in which the employer and/or employee make contributions to an individual account. This account is established for each participating employee, and its value is determined by the amount contributed and investment returns. Unlike a defined benefit plan, where the retirement benefit is based on a predetermined formula, a defined contribution plan does not guarantee a specific benefit amount upon retirement.
In a defined contribution plan, the contributions are typically a percentage of the employee’s salary. These contributions can be made on a pre-tax basis, reducing the employee's taxable income. Moreover, employers may offer a matching contribution where they match a portion of the employee's contribution, up to a certain percentage or dollar amount. The employee has the ability to choose how their contributions are invested, often through a menu of investment options such as mutual funds, stocks, and bonds.
Upon retirement or separation from employment, the employee has the opportunity to withdraw the funds accumulated in their individual account. The final retirement income is dependent on the contributions made, the investment performance, and any withdrawals made. This places the investment risk and responsibility on the employee, as opposed to the employer, who bears the investment risk in a defined benefit plan.
Overall, a defined contribution plan provides individuals with a retirement savings vehicle that allows for flexibility and personal control over investment decisions, while still benefitting from potential employer contributions.
