Defined contribution plans: How they work & how to maximize them

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. They include:

• 401(k)s
• 403(b)s
• 457(b)s

You and your employer both can contribute funds into this account up to certain limits set by the IRS each year. 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.

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.
• Roth-style defined contribution plans (such as a Roth 401(k), Roth 403(b), and Roth 457(b)) have both "tax now" and "tax never" features. Since taxes already have been paid on Roth contributions when they were made, there will be no additional tax liability when you take distributions in retirement. Additionally, your earnings will be tax-free if you make a qualified distribution.¹

Defined benefit plans, also known as pensions, are offered by employers to help employees plan for a specific income in retirement. They also incentivize a long 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. In addition to the annuity option, the company many offer a lump sum distribution, which then can be rolled to an IRA.

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.²

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.

Consider these four strategies to optimize your retirement savings:

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.

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.

Additional things to note:

• Traditional IRA contributions may be deductible on your tax return.³
• Roth IRAs have income limits to participate.⁴

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. The "pay yourself first" method is 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 always can 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.

The IRS sets annual contribution limits for account holders of defined contribution plans. Additionally, people 50 and older can contribute even more through a catch-up contribution.

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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 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.