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Practical guidance for HR benefits professionals
One of the most common topics in retirement savings is the 401(k). While it’s a popular option, the 401(k) is just one example of a broader category called defined contribution plans. These plans have become the foundation of retirement savings for millions of workers, and have replaced traditional pensions in most industries. But what exactly is a defined contribution plan, and why has it become so popular?
What is a defined contribution plan?
A defined contribution plan is an employer-sponsored retirement savings program designed for the employee (and often the employer as well) to contribute money into an individual account set up in the employee’s name. Unlike a defined benefit plan (frequently referred to as a pension), which guarantees a specific payout at retirement, a defined contribution plan doesn’t promise a fixed income. Instead, the amount available at retirement depends on two main factors:
- How much is contributed, and
- How investments perform over time.
This structure provides more control but also places more responsibility on the employee.
Common examples of defined contribution plans include 401(k) plans for private-sector employees, 403(b) plans for those working in education or nonprofits, and 457(b) plans for government workers. These plans have some similarities such as tax advantages, flexibility in contributions, and portability if the worker changes employers. That combination makes them appealing for today’s workforce, where job changes are becoming more frequent.
How does a defined contribution plan work?
The workings are straightforward but understanding them is important. First, the individual decides how much of their paycheck they want to contribute. Many people choose a percentage of their salary, and contributions are often made on a pre-tax basis, which lowers their taxable income for the year. Some plans also offer Roth options, where contributions are made after taxes but withdrawals in retirement are tax-free. This flexibility allows for a custom savings strategy based on the employee’s current tax situation and future expectations.
Employers typically add an incentive by matching a portion of employee contributions. For example, an employer might match 50% of contributions up to 6% of an employee's salary. That’s essentially free money and taking full advantage of it is one of the smartest financial moves an employee can make. Once the money is in an account, employees choose how to invest it. Most plans offer a range of options, including mutual funds, target-date funds, and sometimes company stock. These choices will influence how the account grows over time, so it’s important to review them periodically.
The funds in the account grow tax-deferred, meaning employees won’t pay taxes on investment gains until they withdraw the money in retirement. If they opt for Roth contributions, the growth is tax-free. Either way, the tax benefits are significant and can help savings compound faster.
Ask Alight: What is a Roth 401(k) and why do I need one?
If you expect that your taxes in retirement will be higher than what they are now, Roth 401(k) contributions are generally a good idea.
Defined contribution vs. defined benefit: What’s the difference?
The biggest distinction between these two types of plans is who bears the risk. In a defined benefit plan, the employer guarantees a specific payout, and they manage the investment risk. In a defined contribution plan, the employee takes on that responsibility. The retirement income depends on the contributions and market performance. This shift in risk is one reason defined contribution plans have largely replaced pensions in the private sector. Employers prefer them because they’re easier to manage and less costly over time.
Contribution limits you should know
One of the most powerful aspects of defined contribution plans is how much employees can save. For 2025, the contribution limit for 401(k), 403(b), and 457(b) plans is $23,500 per year. If an employee is 50 or older, they can make catch-up contributions of an additional $7,500. Under SECURE 2.0 rules, individuals age 60 to 63 can contribute even more, up to $11,250 extra. Once employer contributions are factored in, the total annual limit can reach $70,000. These numbers highlight why defined contribution plans are such an effective tool for building wealth over time.
Exploring alternatives to a 401(k)
Not every employer offers a 401(k), but that doesn’t mean there aren’t alternatives. Other retirement account types include Traditional IRAs, which allow for tax-deferred growth, and Roth IRAs, which provide tax-free withdrawals in retirement. If someone is self-employed, they might consider a SEP IRA or a Solo 401(k), both of which offer higher contribution limits than standard IRAs. Health Savings Accounts (HSAs) are another option. While primarily designed for healthcare expenses, an HSA can double as a retirement savings vehicle after age 65, offering triple tax advantages: pre-tax contributions, tax-free growth, and tax-free withdrawals for qualified expenses.
Defined contribution health plans
Interestingly, the concept of defined contributions isn’t limited to retirement. Employers are increasingly adopting defined contribution health plans, where they allocate a fixed dollar amount for employees to spend on healthcare. This approach gives employees more flexibility in choosing coverage while helping employers control costs. It mirrors the philosophy behind retirement plans: providing a set contribution and letting individuals decide how to use it.
While defined contribution retirement plans have been around since the late 1970s, gaining traction after the Revenue Act of 1978 introduced the 401(k), defined contribution health plans emerged more recently as employers sought alternatives to traditional group health insurance. Over the past decade, these health plans have grown in popularity, driven by rising healthcare costs and the need for more personalized benefits. Today, they represent a modern way to balance cost control with employee choice, echoing the same principles that made defined contribution retirement plans a cornerstone of financial planning.
Why choose a defined contribution plan?
The benefits are clear. Tax advantages reduce current or future tax burden. Employer matches boost your savings without extra effort. Flexibility lets the individual adjust contributions and investment choices as their circumstances change. Portability ensures that savings go with the individual if they change jobs. Of course, there are risks. Market fluctuations can impact account balance, so it’s important to invest wisely and review strategy regularly. But with proper planning, these plans can form the cornerstone of financial independence.
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How Alight can help you
Alight knows that a defined contribution plan isn’t just a checkbox on a business’s benefits list, but is an important part of employees’ financial wellbeing. Alight helps organizations design, manage, and optimize retirement programs that deliver real results. From simplifying complex 401(k) options to offering unbiased guidance and high-touch support, we make it easier for your people to feel confident about their financial future.
Our open-architecture platform, industry-leading insights, and personalized tools ensure your plan works for everyone, no matter where they are in their financial journey. If you’re ready to strengthen your benefits strategy and give your employees the clarity and confidence they deserve, let’s talk. We’ll show you how to turn your defined contribution plan into a powerful advantage for your company and your people.
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