What Is a Defined Contribution Plan?

What Is a Defined Contribution Plan?

By Charles Joseph | Editor, Financial Affairs
Reviewed by Corey Michael | Senior Financial Analyst

A Defined Contribution Plan is a type of retirement plan that is sponsored by an employer, where employees can make regular contributions from their wages. These contributions are usually placed into an investment fund, which typically comprises of stocks, bonds, and money market funds. The amount that an employee will receive upon retirement depends on the total amount contributed and how well the investments perform. An example of this kind of plan is the 401k plan, widely adopted in the United States.

Related Questions

1. What is the difference between a Defined Contribution Plan and a Defined Benefit Plan?

A Defined Benefit Plan promises employees a specific payout upon retirement, which is calculated using a formula based on their salary, years of service, and age. In contrast, a Defined Contribution Plan does not promise a specific amount and the retirement payout depends on the performance of the investments.

2. What are the benefits of a Defined Contribution Plan?

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The main benefit of a Defined Contribution Plan is the potential for growth through investments. Since contributions are often invested in various securities, there’s a chance for substantial growth over time. Also, many employers match a portion of their employees’ contributions, further increasing the overall savings.

3. What are the risks associated with a Defined Contribution Plan?

The biggest risk with a Defined Contribution Plan is the potential for poor investment performance. If the investments do not perform well, the retirement savings may not be sufficient. Also, because these plans do not guarantee a specific payout, it’s possible to outlive the savings.

4. Can I contribute to a Defined Contribution Plan if I am self-employed?

Yes, self-employed individuals can set up a Defined Contribution Plan. There are specific types of plans designed for self-employed individuals and small business owners, such as a SEP IRA or a Solo 401k.

5. How much can I contribute to a Defined Contribution Plan?

The contribution limit for Defined Contribution Plans can change year to year. For 2022, the limit is $20,500 for 401(k) plans. If you’re aged 50 or over, you can make an additional catch-up contribution of $6,500. Other types of plans may have different limits.