What to Know About Defined Contribution Plans

How Does a Defined Contribution Plan Work?

A defined contribution plan is any employer-sponsored retirement plan. With many of these plans, you opt to have your employer automatically take a percentage of your paychecks and deposit the money into an account, where the dollars are invested. Your employer may match your contributions either partially or fully up to a percentage of your annual salary.

You generally get to decide how your money is invested based on the plan's offerings, and your account balance can fluctuate up or down over time based on investment performance. This is the main difference between a defined contribution plan and a defined benefit fund or pension, which guarantees a predetermined pension amount at retirement.

Common Defined Contribution Plans

There are many types of defined contribution plans, all with different contribution limits, tax treatments and withdrawal rules. The table below gives a high-level overview of each type of plan.

Types of Defined Contribution Plans

Traditional 401(k) Plans

A traditional 401(k) retirement plan allows you to make contributions out of your paycheck before taxes, thereby reducing your taxable income. You won't pay taxes on your savings until you begin withdrawing in retirement, which you can do starting at age 59½. A 10% penalty applies if you take an early distribution. Unless your plan specifies particular investments, you choose your investments based on the options provided in your plan by your employer.

For 2026, elective employee contributions are capped at $24,500. Employees who are ages 50 to 59 can make an additional catch-up contribution of $8,000, and a higher limit of $11,250 applies to employees ages 60 to 63. Some plans offer employer matching, where your employer also makes contributions up to a certain percentage.

Roth 401(k) Plans

A Roth 401(k) plan is similar to a traditional 401(k) with one main difference: A Roth 401(k) is funded with after-tax dollars. You won't pay taxes on Roth 401(k) distributions as long as you begin doing so after you're 59½ or you meet other eligibility requirements.

If you make an unqualified early withdrawal and you've had the account for less than five years, you will be taxed on earnings, but not your contributions. A 10% penalty may also apply.

The IRS allows you to split 401(k) deferrals between designated Roth contributions and traditional pretax contributions, though the combined amount can't exceed the annual deferral limit. In 2026, that limit is $24,500 with additional catch-up contributions of either $8,000 or $11,250 depending on age.

403(b) Plans and 457(b) Plans

Akin to traditional 401(k) plans, 403(b) and 457(b) retirement savings plans are also funded with pretax contributions from your paycheck that you invest. Nonprofit employers, such as public schools and churches, may offer 403(b) plans.

Certain nonprofits and state and local government agencies offer 457(b) plans. If your employer offers both types of plans, you may be able to contribute to both plans and receive employer matches.

In 2026, the deferral limit for both plans is $24,500. Employees ages 50 to 59 may contribute an extra $8,000, and employees ages 60 to 63 can contribute an extra $11,250. The maximum limit on combined employer and employee contributions is either $72,000 or 100% of the employee's compensation, whichever is less.

SIMPLE IRAs

SIMPLE IRAs are generally offered by employers with 100 or fewer employees. Both employers and employees can contribute to a SIMPLE IRA plan, but your employer cannot offer any other retirement plans at the same time. In 2026, you may contribute up to $17,000 annually, and your employer must make matching contributions of up to 3% of wages. The catch-up contribution is $4,000 per year for employees ages 50 to 59 and $5,250 for employees ages 60 to 63.

If you're an eligible employee and choose not to contribute to your SIMPLE IRA, your employer must contribute 2% of your wages (on up to $360,000 in compensation in 2026) as a nonelective contribution. Another benefit of a SIMPLE IRA is that you are always 100% vested in the SIMPLE IRA money in your account.

SEP IRAs

A SEP IRA is a simplified employee pension plan that any type of employer can set up. Only employers make contributions to a SEP IRA, and all contributions are always 100% vested. In 2026, your employer may contribute up to 25% of your compensation or $72,000, whichever is less. To qualify for a SEP IRA, you must:

• Be at least age 21
• Have worked for the employer in at least three of the last five years
• Receive at least the SEP minimum compensation amount

Employers can exclude employees who are covered by a union agreement and nonresident alien employees who do not have U.S. wages from the employer.

Employee Stock Ownership Plans

An employee stock ownership plan (ESOP) gives you and all other employees shared ownership of the company you work for in the form of shares of company stock. For this reason, you have an interest in seeing the company succeed so its stocks perform well.

ESOPs are established as trust funds with tax-free contributions, typically tied to vesting, where you can earn more shares for each year of service. As an eligible employee, you are fully vested within three to six years.

With an ESOP, you are only taxed on distributions. The amount you're taxed depends on how well the company's stock is performing, and you can roll over your distributions into an IRA or another retirement plan. However, it's usually only possible to cash out your shares if you leave the company, retire, become disabled or pass away.

When you access funds in the account, you will pay taxes on the money withdrawn as capital gains. Plus, if you withdraw funds from your account preretirement and you are under the age of 59½ (age 55 if terminated), you might face a 10% early withdrawal penalty.

Profit-Sharing Plans

Profit-sharing plans give employers the flexibility to choose how much to contribute to the retirement plan each year, including the option to make no contributions at all in some years. Employers can choose which employees can participate and when, but other features of the profit-sharing plan must meet specific requirements by law, such as how contributions are deposited into employees' accounts.

Contribution limits are the lesser of 25% of an employee's compensation or $72,000 in 2026. If you withdraw funds from your account before retirement or if you are under the age of 59½, you may pay an additional 10% early withdrawal penalty.

Defined Contribution Plan vs. Defined Benefit Plan

A defined contribution plan does not promise a specific amount of benefits at retirement, whereas a defined benefit plan does. Here's how they compare.

Pros and Cons of Defined Contribution Plans

Defined contribution retirement savings plans provide many benefits as well as several disadvantages.

The Bottom Line

A defined contribution retirement plan is employer-sponsored and offered as a perk for employees as a part of their job benefits. It can help build a healthy nest egg for your retirement years, no matter your career field or the size of your paycheck. Once you set up your plan, keep track of all the other aspects of your financial life by monitoring your credit with free credit monitoring at Experian. Here you can spot possible identity theft sooner and prevent surprises when you apply for credit in the future.