Defined contribution
A defined contribution plan is a retirement plan to which both the employer and employee may contribute. The plan does not promise a certain benefit when the employee retirees. The term "defined contribution" refers to the fact that the contribution is defined rather than the benefit.

The eventual benefit depends upon the level of contributions by both the employer and the employee and performance of investment choices. Employers are not required to make up for any investment losses sustained by employees within the plan.

Types of defined contribution plans:

  • Money purchase plan - A type of pension plan to which an employer makes fixed contributions upon an employee's behalf. The formula usually requires a contribution of a set percentage of annual compensation up to 25%.
    • Nondiscretionary contributions - Employer payments to a money purchase pension plan are mandatory, regardless of business profits.
    • Annuity payout -Benefits from a money purchase plan often are paid out as an annuity based on the value of the accumulated account balance.
  • Target benefit plan - A retirement plan with contributions based on achieving a "target benefit" for the employee. Also known as an age-weighted pension plan that uses an age-weighted formula to arrive at the target benefit. A target benefit plan is similar to a defined benefit plan, except that the benefits are based on the performance of plan investments and, therefore, are not guaranteed.
    • Nondiscretionary contributions - Employer payments to a target benefit plan are mandatory, regardless of business profits.
  • Profit-sharing plan - A retirement plan designed to share company profits with employees. As the name implies, contributions often are based on company profitability, but the employer has discretion to make contributions regardless of financial performance. An employer, however, must not allow too many consecutive years to pass without making contributions.

    Types of profit sharing plans:
    • 401(k) plan -Qualified plan that allows employees to defer compensation by having it contributed to the plan. Also known as a cash or deferred arrangement (CODA).
      • Elective deferrals - Contributions deferred by employees into the 401(k) plan on a pretax basis.
      • Matching contributions - Employer contributions in an amount tied to how much the employee contributes. Matching contributions typically are capped to a certain percentage of the employee's compensation.
      • Nonelective contributions - Employer contribution that is independent of what the employee contributes. Unlike a matching contribution, nonelective contributions are made regardless of whether the employee contributes anything to the plan.
      • Eligible employers - Profit-making businesses and tax-exempt organizations may offer 401(k) plans to employees. Governmental employers may not adopt a 401(k) plan.
    • Safe harbor 401(k) plan - A type of 401(k) plan deemed to meet nondiscrimination requirements set for 401(k) and other qualified retirement plans. As a result, the plan need not undergo the "actual deferral percentage" nondiscrimination test applied to 401(k) plans.
      • Funding requirements - A safe harbor 401(k) must satisfy one of the following employer contribution requirements:
      • Employer contributes 100% of employee contribution up to 3% of employee compensation, plus 50% of deferrals from 3% to 5%, or;
      • Employer makes nonelective contribution for all eligible nonhighly compensated employees equal to at least 3% of employee compensation.
    • Age-based plan - An age-based profit sharing plan utilizes a formula that bases employer contributions on age. Higher contributions are made on behalf of older employees.
    • Stock bonus plan - A type of profit-sharing plan used by a corporation that uses its own stock to make contributions and distributions. Not available to sole proprietorships and partnerships.
      • Taxation of shares deferred until receipt and can generally be deferred until the employee sells the shares if the shares are distributed in a lump sum to the employee.
    • Employee stock ownership plan (ESOP) - A type of stock bonus plan that can be used by the employer as a tax-advantaged conduit for borrowing from a bank or other lender.
      • An ESOP provides an additional market for shares of closely held corporations.
      • An ESOP must invest primarily in the stock of the sponsoring employer.
      • Contributions to an ESOP are tax deductible, allowing a company that borrows money through an ESOP to deduct both principal and interest payments.
      • Dividends paid on ESOP stock that pass through to employees or are used to repay an ESOP loan are tax deductible.
    • New comparability plan -A profit-sharing plan in which employees are divided into groups that each receive an employer contribution representing a different percentage of compensation. It rewards highly compensated employees more favorably than lower-compensated ones, without regard to age or years of service.
      • Used when owners of a small business are of different ages but earn approximately the same compensation.
      • Relies on cross testing to comply with nondiscrimination rules.
    • Thrift plan - A defined contribution plan that provides for after-tax contributions with matching employer contributions. Often used as an add-on to a 401(k) plan, which provide for pre-tax contribution.


Defined benefit

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