A
Defined Contribution Plan provides individual accounting for
each participant. The contributions are determined by a
formula usually expressed as a percentage of pay. Benefits
at retirement are based upon the contributions, income,
expenses, gains and losses as well as forfeitures that may
be allocated to the participants account.
The
employer determines each year the amount they wish to
contribute to the Plan, within specified limits. The
employer contributions are limited to a maximum of 25% of
compensation for all "eligible employees”. There are
various acceptable formulas for allocating the
contributions.
A
special type of Profit Sharing Plan, which permits employees
to defer a portion of their current pay, on a pre-tax basis,
subject to certain limits. Earnings on the accounts are tax
deferred.Employees are always 100% vested in their money.
Employers may or may not choose to match a portion of the
employee's contribution. Most 401(k) plans allow the
employees to choose or “self-direct” how their money is
invested. Employers may also choose to add a profit sharing
contribution.
These
have a fixed contribution formula. The maximum amount that
can be contributed is the lesser of 25% of an eligible
employee's compensation or $40,000. Since the formula is
fixed in the Plan Document, the contributions are mandatory
each year. As a result of the Tax Law passed in 2001 ‘EGTRRA’,
most Money Purchase Plans will no longer be required since
the contribution amount to Profit Sharing Plans has been
raised to 25%.
A
type of Profit Sharing Plan, which considers the age of the
individual as well as the compensation as a basis for the
allocation of the employers' contribution. This type of plan
favors older employees who have fewer years to retirement.
Also
referred to as “Cross-Tested” plans, these are usually
Profit Sharing Plans in which the contribution formula is
based on a "grouping" or "categories" of
employees. Employers divide employees into different
categories or groups. The contribution formula allocates
different rates or contributions for each category or group.The employer’s contribution as a percentage of
salary can vary greatly by group. The contributions per
group are then tested for nondiscrimination using a
cross-tested method that converts contributions to future
benefits.
The
Employer funds this type of Plan. The retirement
benefits must be definitely determinable. They usually
provide a fixed monthly benefit based upon employee
compensation and length of employment. Benefits are payable
at the plan’s normal retirement age, typically age 65.
They may also be paid at an earlier age on a reduced amount.
These types of plans require an actuary to determine the
contribution that is required each year. Popular for the
small employer, older owners with younger employees can
maximize their own deductions, while contributions for
employees can be kept at a minimum. These plans often allow
deductions of well over the current $40,000 maximum for a
Defined Contribution Plan. Therefore, Defined Benefit Plans
are an excellent tax-planning tool.
