Defined Benefit vs. Defined Contribution Plans
Retirement plans fall into two major categories: defined benefit and defined contribution. Understanding their differences is crucial for making suitable recommendations to clients.
Defined Benefit Plans (Pensions)
A defined benefit plan (pension) promises a specific retirement benefit, typically based on salary and years of service.
How Defined Benefit Works
| Feature | Description |
|---|---|
| Benefit Formula | Based on salary and service years |
| Investment Risk | Employer bears all risk |
| Contributions | Employer funds to meet future obligations |
| PBGC Insured | Yes, up to limits |
| Portability | Generally not portable |
Common Benefit Formulas
Final Average Pay: Benefit = Years of Service × Percentage × Final Average Salary
Example: 30 years × 1.5% × $80,000 = $36,000 annual pension
Career Average: Uses average salary over entire career rather than final years.
Defined Benefit Advantages and Disadvantages
| Advantages | Disadvantages |
|---|---|
| Guaranteed income for life | No individual accounts |
| Investment risk on employer | Not portable between employers |
| PBGC insurance protection | Complex administration |
| Rewards long-tenure employees | Declining availability |
Key Point: Defined benefit plans have become increasingly rare in the private sector due to their cost and complexity for employers.
Defined Contribution Plans
A defined contribution plan specifies the contribution, not the benefit. The retirement benefit depends on contributions and investment performance.
How Defined Contribution Works
| Feature | Description |
|---|---|
| Account | Individual account for each participant |
| Investment Risk | Employee bears investment risk |
| Contributions | Defined amounts from employer/employee |
| PBGC Insured | No (not needed—individual accounts) |
| Portability | Highly portable via rollovers |
Types of Defined Contribution Plans
| Plan Type | Description |
|---|---|
| 401(k) | Most common; employee deferrals + employer match |
| 403(b) | For nonprofits, schools, government |
| 457 | For state/local government employees |
| Profit-Sharing | Employer contributes based on profits |
| Money Purchase | Fixed percentage employer contribution |
| ESOP | Primarily invested in employer stock |
2025 Contribution Limits
401(k), 403(b), and 457 Plans
| Limit Type | 2025 Amount |
|---|---|
| Employee Deferral | $23,500 |
| Catch-Up (Age 50-59, 64+) | $7,500 additional |
| Catch-Up (Age 60-63) | $11,250 additional |
| Total Contributions (Employee + Employer) | $70,000 |
New for 2025: Enhanced catch-up for ages 60-63 allows up to $34,750 total employee contributions.
Profit-Sharing and Money Purchase Plans
| Limit | 2025 Amount |
|---|---|
| Annual Additions | Lesser of 100% of compensation or $70,000 |
| Compensation Limit | $350,000 (for calculating benefits) |
401(k) Plans in Detail
401(k) plans are the most popular employer-sponsored retirement plans.
401(k) Features
| Feature | Description |
|---|---|
| Employee Deferrals | Pre-tax contributions reduce taxable income |
| Employer Match | Common incentive (e.g., 50% match up to 6%) |
| Investment Options | Participant chooses from plan menu |
| Vesting | Employee contributions always vested; employer match may vest over time |
| Loans | Many plans allow loans from your balance |
| Hardship Withdrawals | Permitted for immediate financial need |
Roth 401(k) Option
Many 401(k) plans offer a Roth option:
| Traditional 401(k) | Roth 401(k) |
|---|---|
| Pre-tax contributions | After-tax contributions |
| Tax-deferred growth | Tax-free growth |
| Taxable distributions | Tax-free qualified distributions |
| RMDs required | RMDs required (but can roll to Roth IRA) |
Key Point: Both share the same contribution limits. The choice depends on current vs. future tax rates.
403(b) Plans
403(b) plans (Tax-Sheltered Annuities) are for employees of:
- Public schools (K-12)
- 501(c)(3) tax-exempt organizations
- Churches and religious organizations
403(b) Investment Options
Traditional 403(b) plans offered only annuity contracts. Modern plans typically include:
- Fixed and variable annuities
- Mutual funds (custodial accounts)
15-Year Service Catch-Up
Employees with 15+ years of service at qualifying organizations may contribute an additional $3,000 per year (lifetime max $15,000), on top of standard catch-up contributions.
457 Plans
457 plans are deferred compensation plans for state and local government employees.
457 Unique Features
| Feature | Description |
|---|---|
| Separate Limit | 457 limit is separate from 401(k)/403(b) |
| No Early Withdrawal Penalty | No 10% penalty before 59½ |
| Special Catch-Up | Double contribution in 3 years before retirement |
Key Point: An employee can contribute the maximum to both a 403(b) AND a 457, potentially doubling their tax-advantaged savings.
Plan Comparison Summary
| Feature | Defined Benefit | 401(k) | 403(b) | 457 |
|---|---|---|---|---|
| Benefit | Guaranteed formula | Depends on account | Depends on account | Depends on account |
| Risk Bearer | Employer | Employee | Employee | Employee |
| PBGC Insurance | Yes | No | No | No |
| Portability | Limited | High | High | High |
| Early Withdrawal Penalty | Possible | Yes | Yes | No |
On the Exam
The Series 7 exam frequently tests:
- Distinguishing defined benefit from defined contribution plans
- Knowing current contribution limits
- Understanding which entity bears investment risk
- Recognizing plan eligibility (401k vs. 403b vs. 457)
- Understanding catch-up contribution rules
In a defined benefit pension plan, who bears the investment risk?
What is the maximum employee deferral contribution to a 401(k) plan for 2025 for an employee under age 50?
A teacher at a public high school wants to contribute to an employer-sponsored retirement plan. Which plan type would be available?
Which retirement plan does NOT impose a 10% early withdrawal penalty for distributions before age 59½?
An employee participates in both a 403(b) plan and a 457 plan through their employer. For 2025, what is the maximum total they can defer across both plans (assuming they are under age 50)?
10.3 Individual Retirement Accounts
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