3 Types of Employee Retirement Plans and How They Work

An employer-sponsored retirement plan can be a convenient, safe and easy way to save for retirement. The employer often helps pay for account management fees and can contribute to the account in the employee's name. And many people automatically contribute to these tax-advantaged plans by having money withheld from each of their paychecks.

Understanding Employer Retirement Plans

For many people, the money from an employer-sponsored retirement plan will be their primary source of retirement income, aside from Social Security benefits.

You can additionally or alternatively save for retirement with a tax-advantaged individual retirement account (IRA) on your own. But unless you run a business, the annual contribution limits for IRAs are much lower than the limits for employer-sponsored plans.

You can also put money into non-retirement savings and investment accounts, but many people focus on maxing out their annual contributions in tax-advantaged accounts first. The tax benefits that retirement plans offer can help reduce your tax bill this year and increase your long-term investment gains.

Types of Employer Retirement Plans

There are two primary types of employer-sponsored retirement plans: defined benefit and defined contribution plans.

1. Defined benefit plans

Defined benefit plans—also called pension plans—offer you a guaranteed monthly benefit during retirement in exchange for contributing to the plan while you're working.

Generally, your monthly benefit can depend on several factors, such as how long you worked at the company and your average salary during the final years before you retire. The plan may also offer cost of living adjustments to your benefits after you retire.

Most government employees have access to defined benefit plans, also called public pension plans. But according to the U.S. Bureau of Labor Statistics, only 15% of employees in the private sector had access to a defined benefit plan as of March 2023.

2. Defined contribution plans

Defined contribution plans don't offer a guaranteed income during retirement. Instead, you and your employer can contribute to an investment account in your name.

You may be able to choose from different types of investments, such as several mutual funds, and your account's value can grow or shrink over time. You'll need to manage where you invest your money and determine when and how much to withdraw.

The 401(k) is one of the most well-known examples of a defined contribution plan. But there are also 403(b) plans, 457 plans, employee stock ownership plans and profit-sharing plans. Employers can also sponsor some types of IRAs for their employees.

The investment options and control could potentially lead to higher returns—and therefore more money—than you'd receive from a defined benefit plan. However, there's no guarantee that the money will last the rest of your life. You're taking on the risk of determining how much to contribute, how to invest the money and when to withdraw it.

3. Hybrid plans

Some employers offer hybrid retirement plans that combine elements of defined benefit and defined contribution plans. For example, you might receive a small defined benefit and also have the option of contributing to an employer-sponsored retirement account.

Key Features of Defined Contribution Plans

Most employees in the public sector have access to a defined contribution plan at work, such as a 401(k). The plans can vary in some ways, but they tend to share a few common characteristics:

• Employer and employee contributions: Your employer may contribute to your plan on your behalf, either based on your salary or as a match when you contribute.
• Contribution limits: The IRS determines the total amount you can contribute to your 401(k) each year. The contribution limit is $23,500 for 2025, but it tends to increase over time. If you're 50 or older, you can also make catch-up contributions.
• Tax advantages: You may have access to a traditional and a Roth 401(k) from work. One of the main differences is that your contributions to a traditional account could be tax deductible now, but you'll have to include your withdrawals as taxable income later. With a Roth account, you don't take a deduction today, but your withdrawals could be tax-free later. As a general rule of thumb, it may be best to contribute to a traditional account if you think you're in a higher tax bracket now than you will be during retirement.
• Vesting schedules: Your 401(k) contributions are immediately vested—you own the entire amount right away. However, your employer can use a vesting schedule to determine when you take ownership of the employer contributions. For example, if the vesting schedule gives you 20% ownership at the end of each year, you'll need to work at the company for six years before you're 100% vested. If you leave or are fired before that, you may forfeit a portion of the employer's contributions.
• Early withdrawal penalties: The money in your 401(k) is intended for retirement. You may have to pay a 10% penalty if you withdraw funds before you turn 59½, unless your withdrawal qualifies for an exception.

Making the Most of Your Employer Retirement Plan

There are several common ways to maximize the benefits of a defined contribution plan:

• Max your employer match: Employers often cap how much they'll contribute to your account. For example, your company might give you $1 for every $1 you contribute, up to a total of 5% of your salary. Try to contribute enough each paycheck to receive your company's entire matching amount.
• Consistently increase your contributions: Getting your full match is a good starting goal, but that won't necessarily give you enough money during retirement. Try to increase your contribution amount a little each year.
• Compare investment options and fees: Many 401(k)s allow you to choose from different investment options, such as different mutual funds. Compare the options' holdings, goals and fees to see which one might align with your retirement plans.

Starting early, even if you can't afford to contribute a lot each paycheck, can also be important. The longer you hold onto your investments, the more time you have to benefit from compounding returns.

Average 401(k) balances

Average account balances can be interesting if you're wondering how much your peers are saving for retirement. Vanguard's How America Saves 2024 report breaks down the 2023 average and median amounts in several ways, including by age and income.

Navigating Changes and Challenges

Contributing to employer-sponsored retirement plans can be an important part of your financial plan, but retirement could be years—or decades—away. In the meantime, you may want to use some of the money for an emergency or if you change jobs. Understanding your options and the repercussions will be important for making an informed decision.

• Getting money out early: You generally can't take money out of a defined benefit plan until you retire. If you have a 401(k) or other defined contribution plan, you might be able to make early withdrawals if you pay a penalty and income taxes on the money. Some defined contribution plans also let you take out a loan from your retirement account. You'll have to repay the loan, plus interest, but you'll be paying yourself back.
• Adjusting your plan as you age: You may want to adjust your contribution amounts and investment options as you near retirement. Generally, people move their money into lower-risk investments.
• Managing your plan when you change jobs: You can take all the vested money in your defined contribution plan with you if you change jobs. You might be able to transfer the money into a 401(k) at your new company or roll over your 401(k) into an IRA. You may have fewer options with defined benefit plans, but sometimes you can take a refund early instead of waiting to collect pension benefits when you retire.

You'll also want to keep an eye on how changing regulations and tax laws could affect your retirement accounts. For example, the Secure 2.0 Act became law in 2022 and allows people who are 60 to 63 years old to make even larger catch-up contributions to their 401(k)s.

Planning Beyond Employer Retirement Plans

Employer-sponsored retirement plans can be a great way to save for the future, but they aren't your only option. You can also invest in an IRA on your own—traditional and Roth options are available.

In addition, you can set aside savings in high yield savings accounts or CDs, and you can invest in brokerage accounts that don't offer tax benefits. Although the lack of tax benefits can decrease long-term returns, you'll have penalty-free access to this money at any time.

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