If you are working on your estate plan, you might see references to defined benefit plans and defined contribution plans in tax documents or when doing research. These names refer to specific types of retirement plans, and it can be important to understand the difference.
What Is a Defined Benefit Plan?
A defined benefit plan is sometimes called a pension. It promises you a monthly benefit once you retire. The pension plan either may describe the benefit as a fixed dollar amount, such as $200 every month during your retirement, or it may calculate your benefit based on a formula. The formula method is most common, and plan formulas may consider how long you worked for a company or government agency and what your salary was.
Most often, you do not contribute any money toward the defined benefit plan before your retirement. The company or agency where you works funds the plan and provides it as an employee benefit in addition to your salary or wages. Sometimes, employees may have a mandatory or voluntary contribution amount. Defined benefit plan benefits are usually protected by federal insurance.
What Is a Defined Contribution Plan?
In contrast to a defined benefit plan, the amount of benefits from a defined contribution plan depends on contributions by the employee or the employer. Either the employee, the employer, or both contribute to an individual account for the employee. Sometimes, the contribution rates are fixed, and other times the employee or employer can vary the contribution amount. Employers may “match” employee contributions up to a certain amount.
Usually, contributions are invested in securities on the employee’s behalf. As a result, the total amount in the account can vary due to investment gains and losses. The employee receives the account balance upon retirement or on a schedule during retirement.
Defined contribution plans may be referred to as pensions, like defined benefit plans, but they work a little differently. 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans are all defined contribution plans.
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