by A defined contribution plan is a common workplace retirement plan in which an employee contributes money and the employer typically makes a matching contribution. Two popular types of these plans are 401(k) and 403(b) plans. Defined contribution plans are the most widely used type of employer-sponsored benefit plans in the United States. The plan may require that you enroll yourself to take advantage.
A defined contribution (DC) plan is a type of retirement plan in which the employer, employee or both make contributions on a regular basis. Individual accounts are set up for participants and benefits are based on the amounts credited to these accounts (through employee contributions and, if applicable, employer contributions) plus any investment earnings on the money in the account. In defined contribution plans, future benefits fluctuate on the basis of investment earnings. The most common type of defined contribution plan is a savings and thrift plan. Under this type of plan, the employee contributes a predetermined portion of his or her earnings to an individual account, all or part of which is matched by the employer.
Defined contribution plans and defined benefit plans have a number of notable differences. In a defined contribution plan, both you and your employer can contribute to your individual account. For some plans, you may be required to wait up to one year before enrolling. There may also be a waiting period before any contributions your employer makes to the account become yours to keep.
In a defined benefit plan, generally only your employer contributes and you get a monthly payout in retirement. There are two types of defined benefit plans: Traditional pensions and cash-balance plans. Both plans automatically enroll participants. However, for some defined benefit plans, you must wait some period of time before you are enrolled and/or the benefits become yours to keep.
Defined-contribution plans accounted for $8.2 trillion of the $29.1 trillion in total retirement plan assets held in the United States as of June 19, 2019, according to the Investment Company Institute. The defined-contribution plan differs from a defined-benefit plan, also called a pension plan, which guarantees participants receive a certain benefit at a specific future date.
Defined contribution plans take pre-tax dollars and allow them to grow in capital market investments on a tax-deferred basis. This means that income tax will ultimately be paid on withdrawals, but not until retirement age (a minimum of 59½ years old, with required minimum distributions (RMDs) starting at age 72).
The idea is that employees earn more money, and thus are subject to a higher tax bracket as full-time workers, and will have a lower tax bracket when they are retired. Furthermore, the income that is earned inside the account is not subject to taxes until it is withdrawn by the account holder (if it’s withdrawn before age 59½, a 10% penalty will also apply, with certain exceptions).
Contributions made to a defined-contribution plan may be tax-deferred. In traditional defined-contribution plans, contributions are tax-deferred, but withdrawals are taxable. In the Roth 401(k), the account holder makes contributions after taxes, but withdrawals are tax-free if certain qualifications are met. The tax-advantaged status of defined-contribution plans generally allows balances to grow larger over time compared to accounts that are taxed every year, such as the income on investments held in brokerage accounts.
Employer-sponsored defined-contribution plans may also receive matching contributions. More than three-fourths of companies contribute to employee 401(k) accounts based on the amount the participant contributes. The most common employer matching contribution is 50 cents per $1 contributed up to a specified percentage, but some companies match $1 for every $1 contributed up to a percentage of an employee’s salary, generally 4%–6%. If your employer offers matching on your contributions, it is generally advisable to contribute at least the maximum amount they will match, as this is essentially free money that will grow over time and will benefit you in retirement.
India
Central Government employees in India who joined after January 1, 2004 participate in National Pension Scheme which is defined contribution plan run by Pension Fund Regulatory Authority of India. Earlier employees were under Defined Benefit Plan.
All Government and Private sector organizations had to offer Provident Fund (PF) which is a type of Defined Contribution Plan. The NPS which was started in 2004 is a recent option given to all Central Government employees. The 10% of contribution made by the employer and employees are mandated by the regulations. Additionally, employees are given the ability to opt for an additional contribution if they so desire. All contributions are managed by the PF authority. PF authority choose the investment vehicle; however, the beneficiaries are given a standard % of returns on their contribution. Some large private sector organizations have also formed their Trust to manage the contributions received from its employees.
United Kingdom
In the UK the shift from defined benefit to defined contribution retirement plans has elevated significantly, to the point where many large DB plans are no longer open to new employees. This momentum has been employer-driven and is considered a response to a combination of factors such as pension underfunding, declined long-term interest rates and the move to more market-based accounting. The focus is now on managing pension fund assets in relation to liabilities instead of market benchmarks. The Pensions Policy Institute estimates that in 2013 there were approximately 8 million private sector workers building up DC benefits, compared to approximately 1 million building up DB benefits. However, one point of concern with these schemes is that employers often contribute less than what they would under final salary plans. According to the National Association of Pension Funds (NAPF), employers contribute on average 11% of salary into final salary schemes, compared to only 6% to money purchase. This indicates that individuals will have to save more of their own income into a retirement fund in order to accomplish a satisfactory retirement income. Companies such as Aon Hewitt, Mercer and Aviva recognise these challenges and have identified the need to help new generations of workers with their retirement funding plans.
Budget 2014: All tax restrictions on retired people’s access to their registered retirement pots are removed, ending the requirement to buy an annuity. The taxable part of the registered retirement pot is taken as cash on retirement to be charged at normal income tax rates. The increase in total registered retirement savings that people can take as a lump sum to £30,000.
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