By Denise Appleby
Under a defined-benefit plan, employees' retirement benefits are predetermined by their compensation, years of service and age. For example, the plan may determine that upon retirement an employee will receive 1% of his or her average salary for the last five years of employment for every year of service with the employer. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. (These plans are becoming increasingly rare. Read The Demise Of The Defined Benefit Plan for more insight.)
Let's use an example to demonstrate:
John was employed by ABC Company for 10 years, and during the last five years of employment, John's compensation was as follows:
John's average compensation for these last five years of employment is $71,000, and 1% of John's average salary for these five years is $710.
Under the provisions of the plan, John will receive $710 for 10 years, that is, 1% of his average salary for his last five years of employment for the number of years he was employed by the company.
The employer will make contributions that, based on actuarial assumptions including projected growth of investments, are required to reach the predetermined retirement benefit. Should the performance of plan investments fall below the projected amount, the employer is required to make additional contributions to make up for the shortfall.
The contribution limits for defined-benefit plans are significantly higher than the limits of defined-contribution plans.
The operation of a defined-benefit plan, which is beyond the scope of this tutorial, may require the assistance of an actuary as contributions are based on actuarial assumptions and formulas. (Discover some of the risks of defined benefit plans in Is Your Defined-Benefit Pension Plan Safe?)
A defined-contribution plan does not promise a specific amount of benefit at retirement. Employees or employers (or both) contribute to these plans. Typically, the contribution will be a percentage of compensation up to a certain dollar amount. Depending on the plan type, the contributions made by the employer may be mandatory or discretionary. The contributions are invested on the employee's behalf, and the benefits paid to employees are based on contributions and any earnings or losses. For defined-contribution plans, employers are not required to make up for any losses on investments. A defined-contribution plan can be a profit-sharing plan, an employee stock ownership plan (ESOP), a 401(k) plan or a money-purchase pension plan.
Profit-Sharing or Stock-Bonus Plans
A profit-sharing plan is typically used for sharing profits from the business with employees, but an employer may make profit-sharing contributions regardless of whether the business had profits for the year. Contributions to the plan are usually discretionary, which means that the employer may choose not to contribute to the plan every year. Despite this flexibility, however, the employer must take care not to allow too many consecutive years to pass before contributions are made. The IRS does not specify how many consecutive years are unacceptable but does indicate that contributions to the plan must be substantial and recurring.
A stock-bonus plan is a type of profit sharing by which a corporation uses its own stock to make contributions and distributions. These plans, however, are not available to sole proprietorships and partnerships.
A profit-sharing and stock-bonus plan may include a 401(k) plan feature.
Profit-sharing and stock-bonus plans are suited for employers who are newly established and are unable to determine profit patterns or who want to have flexibility with making plan contributions.
Money-Purchase Pension Plan
In general, an employer has more flexibility in contributing to a profit-sharing plan than to a money-purchase pension plan.
Contributions to a money-purchase pension plan are fixed and are not based on business profits. For example, if according to the plan each participant will receive 10% of eligible compensation, each eligible employee must receive the contribution without regard to the employer's profits for the year.
A money-purchase pension plan is suited for employers who are able to determine profit trends and do not mind being mandated to make contributions to the plan each year.
401(k) Profit-Sharing Plan
A 401(k) plan is a qualified plan that allows employees to defer receiving compensation in order to have the amount contributed to the plan. This arrangement is commonly referred to as a cash or deferred arrangement (CODA). Contributions deferred by employees are referred to as elective deferrals, which are typically made to the 401(k) plan on a pretax basis. An employer may chose to have a stand-alone 401(k) plan or a profit-sharing plan with a 401(k) feature. The employer may also choose to make matching, nonelective or profit-sharing contributions to the plan. A 401(k) plan is suited for an employer who wants employees to assist with funding the plan. (For more insight, read The 4-1-1 On 401(k)s.)
An employer may add an age-weighted feature, which allocates a higher percentage of plan contributions to older employees. The assumption is that older employees have less time before they retire and therefore less time to accumulate retirement savings. Age-weighted plans are suitable for business owners who are considerably older than their employees and who may not have had the opportunity to accumulate retirement savings in their earlier years.
Employee Stock Ownership Plans (ESOPs)
Employee stock ownership plans (ESOPs) are a form of defined-contribution plan in which the investments are primarily in the employer's stock. Congress authorized the creation of ESOPs as one method of encouraging employee participation in corporate ownership. (Find out more in Should You Consider An ESOP?)
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