10.2 Defined Benefit vs. Defined Contribution
Key Takeaways
- Defined benefit (pension) plans promise a formula-based benefit and the employer bears all investment risk.
- Defined contribution plans specify the contribution, not the payout; the employee bears investment risk.
- 2026 employee deferral limit for 401(k)/403(b)/457 is $24,500, with an $8,000 catch-up at 50 (or $11,250 at ages 60-63).
- The 415(c) total annual additions limit (employee plus employer) is $72,000 for 2026.
- 457 plans have no 10% early-withdrawal penalty and a separate limit, so a 403(b) and a 457 can both be maxed.
Two Families of Employer Plans
Every employer-sponsored qualified plan is either defined benefit or defined contribution. The single most tested distinction is who bears the investment risk. Memorize it: in a defined benefit (DB) plan the employer bears the risk; in a defined contribution (DC) plan the employee bears it.
Defined Benefit (Pension) Plans
A defined benefit plan promises a specific retirement benefit, usually computed from salary and years of service. The employer funds the plan actuarially and must contribute whatever is needed to meet the promise, regardless of how the investments perform. These plans are PBGC-insured and reward long tenure but are costly to administer and increasingly rare.
Final-average-pay formula: Annual Benefit = Years of Service x Benefit Percentage x Final Average Salary.
Worked example: 30 years of service x 1.5% (0.015) x $80,000 final average salary = $36,000 per year for life. A career-average formula uses lifetime average pay instead of the final years.
| DB Advantages | DB Disadvantages |
|---|---|
| Guaranteed lifetime income | No individual account; not portable |
| Employer bears market risk | Complex, expensive administration |
| PBGC insurance protection | Declining availability in private sector |
Defined Contribution Plans
A defined contribution plan fixes the contribution going in; the ending benefit depends entirely on contributions plus investment results. Each participant has an individual account, so balances are highly portable via rollover, and there is no PBGC coverage because there is no promised payout.
| DC Plan | Who uses it |
|---|---|
| 401(k) | Private for-profit employers; employee deferrals + match |
| 403(b) | Public schools and 501(c)(3) charities |
| 457(b) | State/local government and some nonprofits |
| Profit-Sharing | Employer contributes a discretionary share of profits |
| Money Purchase | Employer contributes a fixed percentage each year |
| ESOP | Invests primarily in employer stock |
2026 Contribution Limits (IRS Notice 2025-67)
| Limit | 2026 Amount |
|---|---|
| Employee elective deferral (401(k)/403(b)/457) | $24,500 |
| Catch-up, age 50-59 and 64+ | +$8,000 |
| Enhanced catch-up, ages 60-63 (SECURE 2.0) | +$11,250 |
| 415(c) total annual additions (employee + employer) | $72,000 |
| Annual compensation limit for benefit calculations | $360,000 |
So an employee age 55 may defer $24,500 + $8,000 = $32,500, while an employee age 61 may defer $24,500 + $11,250 = $35,750. The $72,000 415(c) ceiling caps the combined employer-plus-employee figure (deferrals, match, and forfeitures), but catch-up contributions sit on top of the 415(c) limit.
401(k) Plans in Detail
The 401(k) is the dominant DC plan. Employees elect pre-tax salary deferrals, employers frequently add a match (e.g., 50 cents per dollar on the first 6% of pay), participants choose investments from a plan menu, and many plans permit loans and hardship withdrawals. A Roth 401(k) option accepts after-tax dollars for tax-free qualified growth; both options share the same $24,500 deferral limit.
| Traditional 401(k) | Roth 401(k) |
|---|---|
| Pre-tax contributions | After-tax contributions |
| Tax-deferred growth | Tax-free qualified growth |
| Distributions taxable | Qualified distributions tax-free |
Under SECURE 2.0, beginning in 2026 catch-up contributions for high earners (prior-year wages over roughly $145,000, indexed) generally must be made on a Roth basis.
403(b) and 457 Plans
403(b) plans (tax-sheltered annuities) serve public-school employees and 501(c)(3) charities and historically held annuities and mutual-fund custodial accounts. A unique feature is the 15-year service catch-up: employees with 15+ years at a qualifying employer may add up to $3,000/year, $15,000 lifetime, separate from the age-50 catch-up.
457(b) plans for state and local government employees have two prized traits: no 10% early-withdrawal penalty before age 59 1/2, and a separate contribution limit. A government employee with both a 403(b) and a 457(b) can therefore defer the full $24,500 to each, totaling $49,000 in 2026 (before catch-ups). 457 plans also offer a special "last 3 years" double-up catch-up before normal retirement age, allowing up to twice the annual limit in those final years to make up for prior under-contribution.
Small-Business and Self-Employed Plans
The Series 7 also tests employer plans built on IRA mechanics for small employers and the self-employed. These are technically defined contribution arrangements but funded into IRAs:
| Plan | Who uses it | 2026 employer/employee features |
|---|---|---|
| SEP IRA | Self-employed and small firms | Employer-only contribution up to 25% of compensation, max $72,000; immediately 100% vested |
| SIMPLE IRA | Employers with <= 100 employees | Employee defers up to $17,000 (approx.); employer must match up to 3% or contribute 2% for all |
| Solo 401(k) | Owner-only businesses | Owner contributes as both employee ($24,500) and employer (profit-sharing) up to $72,000 |
A crucial trap: a SEP IRA receives employer contributions only — employees make no salary deferrals — and contributions are immediately vested. A SIMPLE IRA allows employee deferrals plus a mandatory employer match (dollar-for-dollar up to 3% of pay) or a 2% nonelective contribution for every eligible worker. SIMPLE plans also carry a steep 25% early-withdrawal penalty (instead of the usual 10%) for distributions taken within the first two years of participation, a frequently tested detail.
Profit-Sharing and ESOP Mechanics
A profit-sharing plan lets the employer decide each year whether and how much to contribute (it need not actually have profits), allocating contributions among participants under a written formula. A money purchase plan, by contrast, locks the employer into a fixed annual percentage regardless of profitability. An Employee Stock Ownership Plan (ESOP) invests primarily in the employer's own stock, giving employees an ownership stake; participants nearing retirement gain diversification rights so they are not over-concentrated in a single security.
| Feature | DB | 401(k) | 403(b) | 457(b) |
|---|---|---|---|---|
| Risk bearer | Employer | Employee | Employee | Employee |
| PBGC insured | Yes | No | No | No |
| 10% early penalty | Possible | Yes | Yes | No |
| Portability | Limited | High | High | High |
In a defined benefit pension plan, who bears the investment risk?
What is the 2026 maximum elective salary deferral to a 401(k) for an employee under age 50?
A public high school teacher wants an employer-sponsored salary-deferral retirement plan. Which is most likely available?
Which plan does NOT impose the 10% federal penalty on distributions taken before age 59 1/2?
An eligible government employee under age 50 participates in both a 403(b) and a 457(b). What is the maximum total elective deferral across both plans in 2026?