How do defined contribution plans work?
- What are defined contribution plans?
- How do defined contribution plans work?
- How does the money get invested?
- What tax benefits do 401(k)s offer?
- Do I have to contribute to my plan?
- Why is a 401(k) such a good deal?
- When do I pay tax on a 401(k)?
- How is a Roth 401(k) different?
- What is a matching contribution?
- How does vesting work exactly?
- How much should I contribute to my plan?
- What if I can't invest the maximum right now?
- What if I need the money before I retire?
- What if I leave my job?
All defined contribution plans basically work the same way. You decide how much you want to contribute, and your employer puts the money into your individual account on your behalf. The investment happens through payroll deduction: You decide what percentage of your salary you'd like to contribute and, from then on, that amount comes straight out of your paycheck and goes into your account automatically, without you having to lift a finger. Your paycheck will be smaller as a result - though not as small as you might think, thanks to the tax benefits involved.
You decide what you want the money in your plan to be invested in. Your employer's plan will have a limited selection of investments for you to choose from. When you leave your job, you still maintain ownership over your account.
Many employers also agree to kick in some of their own money once you've decided to put your money in. This is known as a matching contribution. Many employers kick in 50 cents for every dollar you contribute, up to a certain percentage of your salary (perhaps 3% to 6%). So, if over the course of the year you contribute $3,000, your company would put in $1,500.
