Defined Contribution Plans

Companies have changed from, or rely less on, the more costly defined benefit plans. Instead, many companies now use less expensive and more flexible defined contribution plans.

The way that a defined contribution plan works is that either an individual alone, or an employee and the employer make contributions into the plan, usually based on a percentage of the employee's annual earnings. Each participant has an individual, separate account. There is no way to determine in advance what the final payout at retirement will be. Benefits depend on how much was contributed in the employee's name and how well the pension fund investments performed. So, the risk of fluctuations in investment return is shifted to the employees.

The government sets a limit on how much can be contributed in an individual's name each year no matter how many different plans he or she participates in. The total amount that can be contributed in one employee's name for 2013 is the lesser of $51,000 ($50,000 for 2012) or 100 percent of the employee's annual earnings. The contributions are allocated to separate accounts for each participant based on a definite, predetermined formula. Forfeitures can be reallocated to remaining participants.

Types of defined contribution plans. Defined contribution plans are actually a broad range of programs including profit-sharing plans, money purchase plans, 401(k) plans, employee stock ownership (ESOP) plans:

• Profit-sharing plans. Profit-sharing plans are a very popular type of plan, especially for small businesses. They offer the greatest flexibility in contributions and are simple to administer. Initially developed to encourage hard work and loyalty, the plans encourage companies to set aside money in the employees' names when the company shows a profit. Generally, the employer has the discretion to contribute or may decide not to contribute in any given year, if it so desires.
• Money purchase plans. In the money purchase plans, the employer is obligated to contribute even if the company didn't make a profit. The contributions are determined by a specific percentage of each employee's compensation and must be made annually.
• 401(k) plans. Many qualified defined contribution plans permit participating employees to make contributions to a plan on a before-tax basis. These plans are called cash or deferred arrangements (CODAs, or more popularly, 401(k) plans, named after the Internal Revenue Code provision dealing with CODAs). They enable participants to save for retirement on a before-tax basis. The employees authorize their employer to reduce their salary and contribute the salary reduction on their behalf to a qualified retirement plan. In addition to these employee elective deferrals, an employer can make supplemental contributions on behalf of employees. These employer contributions can be subject to a vesting schedule, but the employees' contributions must be nonforfeitable. The employee's elective deferral to all 401(k) plans is limited to $17,500 for 2013 ($17,000 for 2012; this amount may be adjusted for inflation). Individuals age 50 and over can contribute an additional $5,500 for the year. The employer contribution is also subject to separate, complex limitations. Generally, withdrawals from 401(k) plans are not permitted before age 59¹/₂ unless the employee retires, dies, becomes disabled, changes jobs, is a reservist called or ordered to active military duty for more than 179 days, or suffers a financial hardship as defined by Internal Revenue Service regulations. 401(k) plans are often offered in combination with other plans, such as profit-sharing plans.
• Employee Stock Ownership Plans (ESOPs). An ESOP is a stock bonus plan or a combination stock bonus plan and money purchase plan that is designed to invest primarily in qualifying employer securities and to use borrowed funds to do so. An ESOP is funded by employer contributions of stock in the corporation or allows you to buy shares of stock as a plan investment option. ESOPs must comply with all the requirements imposed on other types of defined-contributions plans. ESOPs cannot be integrated with Social Security.

Other examples of defined contribution plans for small businesses to consider include:

• SIMPLE plans
• SEPs (simplified employee pensions)
• SARSEPs (salary reduction simplified employee pensions: these plans may no longer be started, but an existing SARSEP plan may be continued)