6.2.2.2. Defined Contribution Plans
A defined contribution plan is a retirement plan in which the contribution is defined but the ultimate benefit to be paid out is not. More and more, companies are moving to defined contribution plans to avoid the high costs of pensions. In a defined contribution plan, investment risks and investment rewards are assumed by the participant rather than by the employer. In this kind of plan, participants contribute a portion of their pre-tax earnings. Participants have their own individual accounts and choose from several different investment options. Often employers will match at least part of the employee’s contributions. Employer contributions are often on a vesting schedule that defines ownership of the funds by time interval. A participant’s benefits will depend on the amount of his contributions, the amount of his employer’s contributions, the performance (positive or negative) of the investments over the participant’s career, and any expenses incurred in managing the account. The contributions and earnings grow tax-free until they are withdrawn, at which time they are taxed as ordinary income.
Defined contribution plans are subject to IRS contribution limits which vary by the type of plan. Contributions may be limited by the participant’s income. Some plans may allow “catch up” contributions for participants over 50 years old.
Defined contribution plan benefits are typically paid out in a lump sum or in installments, but they may also be paid as an annuity over a person’s lifetime. The most common examples of defined contribution plans are profit-sharing plans and 401(k) plans. The types of plans include:
• Profit-sharing plans—a plan for corporate employees in which benefits are linked to corporate profits through a pre-determined formula. Distributions are not guaranteed, but when there is a distribution, it is made to all employees as a percentage of their salaries.
• 401(k) plan—a pla