Types of Retirement Plans - Types and Provisions of Qualified Plans

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
Related Articles
  1. Investing

    How To Build a Currency Hedged Strategy?

    We are still unsure of how to implement a currency hedge strategy based on the dollar's movement. So let’s focus on what’s easier to measure: time horizon.
  2. Mutual Funds & ETFs

    Top 3 Equity Energy Mutual Funds

    Explore detailed analysis of the top three equity energy mutual funds, and learn about the characteristics and suitability of these funds.
  3. Mutual Funds & ETFs

    Top 3 Emerging Markets Bond Mutual Funds

    Discover detailed analysis of the top three mutual funds offering exposure to the emerging markets bonds, and learn about the suitability of these funds.
  4. Stock Analysis

    The Biggest Risks of Investing in Netflix Stock

    Examine the current state of Netflix Inc., and learn about three of the major fundamental risks that the company is currently facing.
  5. Mutual Funds & ETFs

    3 Fixed Income ETFs in the Mining Sector

    Learn about the top three metals and mining exchange-traded funds (ETFs), and explore analyses of their characteristics and how investors can benefit from these ETFs.
  6. Professionals

    Career Advice: Financial Planner Vs. Wealth Manager

    Understand the differences between a career in financial planning and wealth management, and identify which is better for you based on your goals and talents.
  7. Mutual Funds & ETFs

    Top 3 Muni California Mutual Funds

    Discover analyses of the top three California municipal bond mutual funds, and learn about their characteristics, historical performance and suitability.
  8. Mutual Funds & ETFs

    Mutual Funds Are Not FDIC Insured: Here Is Why

    Find out why mutual funds are not insured by the FDIC, including why the FDIC was created and how to minimize your risk with educated mutual fund investments.
  9. Investing

    How to Win More by Losing Less in Today’s Markets

    The further you fall, the harder it is to climb back up. It’s a universal truth that is painfully apparent in the investing world.
  10. Personal Finance

    How To Choose A Financial Advisor

    Many advisors display similar skillsets that can make distinguishing between them difficult. The following guidelines can help you better understand their qualifications and services.
  1. Equity Risk Premium

    The excess return that investing in the stock market provides ...
  2. Net Line

    The amount of risk that an insurance company retains after subtracting ...
  3. Political Risk Insurance

    Coverage that provides financial protection to investors, financial ...
  4. Maximum Drawdown (MDD)

    The maximum loss from a peak to a trough of a portfolio, before ...
  5. Gross Exposure

    The absolute level of a fund's investments.
  6. Priori Loss Estimates

    A technique used by insurance companies to calculate loss reserves.
  1. Why have mutual funds become so popular?

    Mutual funds have become an incredibly popular option for a wide variety of investors. This is primarily due to the automatic ... Read Full Answer >>
  2. Can your car insurance company check your driving record?

    While your auto insurance company cannot pull your full motor vehicle report, or MVR, it does pull a record summary that ... Read Full Answer >>
  3. Do financial advisors work only in banks?

    While the majority of financial advisors work for financial institutions such as banks, a large proportion of them are self-employed ... Read Full Answer >>
  4. Is my IRA/Roth IRA FDIC-Insured?

    The Federal Deposit Insurance Corporation, or FDIC, is a government-run agency that provides protection against losses if ... Read Full Answer >>
  5. Does index trading increase market vulnerability?

    The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>
  6. What are common delta hedging strategies?

    The term delta refers to the change in price of an underlying stock or exchange-traded fund (ETF) as compared to the corresponding ... Read Full Answer >>
Hot Definitions
  1. Ex Works (EXW)

    An international trade term requiring the seller to make goods ready for pickup at his or her own place of business. All ...
  2. Letter of Intent - LOI

    A document outlining the terms of an agreement before it is finalized. LOIs are usually not legally binding in their entirety. ...
  3. Purchasing Power

    The value of a currency expressed in terms of the amount of goods or services that one unit of money can buy. Purchasing ...
  4. Real Estate Investment Trust - REIT

    A REIT is a type of security that invests in real estate through property or mortgages and often trades on major exchanges ...
  5. Section 1231 Property

    A tax term relating to depreciable business property that has been held for over a year. Section 1231 property includes buildings, ...
  6. Term Deposit

    A deposit held at a financial institution that has a fixed term, and guarantees return of principal.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!