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What is a Defined Contribution Pension Plan?

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  • Written By: Mary McMahon
  • Edited By: Kristen Osborne
  • Last Modified Date: 13 September 2016
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A defined contribution pension plan is a retirement benefits plan where employees submit a set amount each month. The plan is defined by the amount of the contributions, rather than the amount of benefits expected during retirement. There are advantages and disadvantages to a defined contribution pension plan and such plans are not available from all employers. When weighing benefits packages, employees may want to familiarize themselves with all the options before making a decision.

In a basic defined contribution pension plan, a set percentage of each paycheck, such as five percent, is deposited into the plan. The employer may make matching contributions, depending on the terms of the plan. As with other retirement plans, while people can make early withdrawals if they need funds, there will be financial penalties, including fines and tax penalties. These are designed to provide an incentive to keep the money in the plan as long as possible.

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Employees do not know the amount of benefits they will receive during retirement, because this is based on how much is paid into the plan over time and how well the funds are invested. Employees can continue paying into the plan until they retire to increase the benefits as much as possible. One advantage to a defined contribution pension plan is that people usually get to choose where their funds are invested. If employees choose wisely, they can increase funds available for retirement. A retirement planner can help people map out an investment plan based on retirement goals and amounts being contributed.

When an employee retires, benefits from a defined contribution pension plan may be accepted in a number of different ways. One option is to take a lump sum payment. Another choice is to accept monthly payments budgeted out over the employee's retirement. In both cases, the income becomes taxable once the employee receives payments. This is important to keep in mind, as employees need to make sure to set aside enough funds to cover taxes when they get benefits payments.

The primary disadvantage to a defined contribution pension plan is that employees don't know how much they will be earning during retirement. Retirement planning can hinge on knowing roughly how much money to expect every month. If this is up in the air, it can be difficult to think ahead for retirement. However, the increased investment flexibility may be appealing to some employees. Some employees balance their risks and have two pension plans, one with benefits defined and one with contributions defined.

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