What is a defined contribution plan?

Getting ready for retirement doesn't happen all at once. It takes small steps to create a comfortable and secure plan that aligns with the type of life you want to live after leaving the workforce. A great place to start is exploring the defined contribution plan offered through your employer.

Defined contribution plans are a popular way to save for retirement due to their relative simplicity and potential tax advantages. However, depending on the types of defined contribution plans offered at your workplace, you may decide to choose a combination of choices rather than focus on one.

A defined contribution plan is a retirement account offered through an employer. Individuals working at for-profit companies are typically offered a 401(k), while those working at public schools or nonprofits often have the option to enroll in a 403(b) plan. Once you contribute to these accounts, you can invest your money in any of the provided mutual funds or other investments available through your particular account administrator.

You and your employer can both contribute funds into this account up to certain limits set by the IRS each year. There are usually management fees associated with the investments you can choose, but it's possible to see what the amount will be and decide on lower-expense options.

One major differentiator between a defined contribution plan and a non-401(k) investment account such as a brokerage account are the tax advantages. Typically, all investments fall into an income tax bucket of either "tax now," "tax later" or "tax never." Traditional defined contribution accounts are often "tax later" since they only require you to pay income tax when withdrawing money in retirement. Meanwhile, Roth-style defined contribution plans are "tax never." Since taxes have already been paid on Roth contributions when they were made, your dollars grow tax-deferred.* And the income you withdraw in retirement will be tax-free.

Defined benefit plans offered via employers help employees plan for a specific income in retirement and incentivize a longer tenure at a company. They offer a lifetime annuity upon retirement that is set at a specific amount, typically calculated based on years of service at the company and an individual's final salary there. Today, these plans—sometimes called pensions—are much less common than they were in the past.

Defined contribution plans, by contrast, are widely available to working adults. They don't guarantee a particular amount of income in retirement and can change in value based on the performance of your investments. A major advantage of defined contribution plans is their portability; unlike with some defined benefit plans, assets can roll over to a Traditional IRA or your new company's 401(k) plan if you change jobs. Portability is dependent on details in the plan document.

There are benefits and drawbacks to both kinds of plans, but defined contribution plans have grown in popularity with employers over the defined benefit plan or pension model. Ultimately, participation is dependent on what your employer offers.

If you don't have a defined contribution plan, you can use an individual retirement account (IRA) to save for retirement. However, many people find that a combination approach that utilizes both their employer's defined contribution plan and an IRA can offer more flexibility.

Here are strategies for making the most of a defined contribution plan.

At many companies, the employer offers a contribution match of some kind in part to encourage employees to save for retirement. This match is an amount they will contribute based on employees' level of saving. For instance, they might offer to contribute 1% of your salary to your retirement account for every 1% you contribute, up to 3%. To access this money fully, you'd have to contribute 3% of your salary into retirement—however, you are effectively compensated at 103% of your salary, which can be a nice opportunity to receive free money while saving for your future.

Traditional 401(k) tax advantages arrive early, when you first earn and contribute the money. This is most advantageous if you expect to earn a higher income now than you will later on. Meanwhile, Roth 401(k) tax advantages arrive in retirement. If you're earning a lower income now but expect your income to grow over time, paying the taxes now through a Roth 401(k) account could mean paying less overall, with no tax liability in retirement on those withdrawals.

One strategy for optimizing your taxes is to shift taxable income to the later seasons of your life when you have lower income overall, as you could be in lower tax brackets. Ideally, you'll qualify for deductions from your taxable income when you have a higher income. For instance, those with a higher income might have their contributions taxed at a 35% rate, while those making lower wages may be taxed at only 10%. Taking these deductions off the top of a higher income can potentially yield greater savings.

The limits for defined contribution plans are rather large relative to the average incomes in the United States.

The IRS limits are:

If you don't have $22,500 or $30,000 to contribute to a plan each year, you're not alone. However, you can compare this option against what's available for an IRA, one of the other leading methods for saving for retirement.

The IRS limits are:

If you find that you can afford to save more than $6,500 a year, you may want to use both an IRA and a defined contribution plan. Defined contribution plans allow you to save much more with tax advantages than you'd have with an IRA alone. IRA contributions are not always deductible on your tax return. This ability is determined based on if you or your spouse are active participants in and employer-sponsored plan and modified adjusted gross income (MAGI).

When you first start a new job or role at your company, your defined contribution plan represents a powerful opportunity. You can choose a dollar amount or a set percentage—anywhere from 1% to 10% or more—to subtract from your paycheck and contribute toward your defined contribution plan. You won't see those funds for years, so saving in this way may mean you never miss the money in the first place. It's a chance to practice good stewardship of your resources without having to make the conscious decision to save each month.

Of course, if you do have a major change in circumstances, you can always reduce that automatic contribution by working with your HR department or plan administrator. You're not locked in forever. With busy lives full of decisions, many of us value the opportunity to make a wise choice like this one time and reap the benefits for years to come.

All forms of retirement savings have benefits and drawbacks. Knowing the structure of defined contribution plans can help you prepare ahead of time and minimize pitfalls.

Some employer contributions aren't "fully vested," or owned outright by you, until you've worked at the company for a certain amount of time. Ask if your company has a vesting schedule—if there's a good chance you might leave this job before the vesting period, you might choose a different way to save for retirement, since you may or may not be eligible to keep your employer's matching contributions if you aren't there for long enough. Your own contributions are always 100% vested.

While IRAs often have many investment options, some defined contribution plans only have a few choices available. These funds may have substantial management fees, which can eat into the returns you gain from your investments. Reviewing the fees on both IRA and defined contribution plan options helps you make informed decisions.

Defined contribution plans do not guarantee you a given monthly or annual payout each year of retirement. You'll need to manage your account's level of risk, especially as your retirement date approaches.

Thrivent's 2022 Retirement Readiness survey revealed that younger generations are more likely to rely on just one savings strategy, whereas those nearing retirement are more likely to have a mix of assets for retirement. Between your day-to-day savings account, your investment accounts and your retirement accounts, you may feel unsure about how to save in a way that equips you for the future.

A trusted Thrivent financial advisor can help you balance out and diversify your accounts. These knowledgeable professionals offer guidance tailored to your individual situation to help you gain clarity about your long-term financial goals. Taking charge of your financial future with a trusted guide can help you feel truly prepared to take the next step toward your retirement.