The Key Differences Between Defined Benefit and Defined Contribution Retirement Plans
There are several significant differences between defined benefit and defined contribution plans. These include both the funding and the way the benefits are received. For instance, defined benefit plans payout a specific amount of income to the participant during retirement. The amount of the income is determined by a formula that includes certain factors like the worker/retiree’s salary, as well as the length of time they were employed by the company. The risk of ensuring that enough income is paid out is borne by the employer, not the employee. So, if the underlying investments do not perform well, then the funds are made up for through the company’s earnings. If the worker/retiree predeceases his or her spouse, the pension income may continue for the surviving individual. The dollar amount may either be the same or reduced. The funds that are received are taxed as ordinary income. In contrast, the contributions that are made by employees to a defined contribution plan are typically done before tax. Therefore, the amount of income tax will be reduced in the year(s) when deposits are made. The earnings that take place in the plan are tax-deferred, meaning that there is no tax due on the growth until the time of withdrawal. Every year, the IRS stipulates the maximum amount that may be contributed to 401(k)s and other defined contribution plans. For 2021, participants who are age 49 and younger can contribute up to $19,500 and those who are 50 and older may deposit an additional $6,500 for a total of $26,000. The participants in 401(k) plans can usually choose from a variety of different investment options. These may include mutual funds, money markets, and/or shares of the sponsoring company’s stock (if applicable). When the employee is ready to retire, the funds that are in the defined contribution plan can be rolled into an annuity or other type of account(s) where an income plan can be created. Unfortunately, if the underlying financial vehicles do not perform well, income could run out at a time when it is still needed.Defined Benefit versus Defined Contribution Plans
Defined Benefit Plans | Defined Contribution Plans | |
---|---|---|
Employee contributions | Depends on the plan | Maximum annual amount |
Earnings | Employer’s responsibility | Tax-deferred (but employee / participant takes all of the risk) |
Investment risk | Employer | Employee / Participant |
Guaranteed income | Yes | No |