Plans offered through an employer either define the benefit to be received when the employee retires or the contributions made into the account. Usually, it is only the contributions that are defined.
Defined Contribution Plans
A defined contribution plan only defines the contributions the employer and/or the employee can make into the plan. The employer is not promising any benefit at retirement.
At many companies, new employees receive paperwork to fill out concerning the 401(k) plan sponsored by the employer as an employee benefit. The employees choose mutual funds, and tell the HR department to deduct X amount from their paychecks to go into the 401(k) account. This way, part of their salary goes straight into a retirement fund and is not taxable currently, just like the money that goes into a Traditional IRA. Pretty attractive, especially if the employer matches what the employees elect to defer from each paycheck.
The amount of the employee's contribution is known as an elective deferral. Employers generally match all or part of an employee's elective deferral up to a certain percentage of compensation, as stipulated in their plan literature. But, they are not required to make matching contributions.
Why might someone choose to participate in a 401(k) even if the company was not matching contributions? Maybe he likes the higher maximum contribution limit vs. the IRA or Roth IRA.
The advantage to a business owner setting up a 401(k) plan is that a vesting schedule can be laid out over several years, meaning that the employer's contributions don't belong to the employee until he is fully vested. However, 401(k) plans come with complicated top-heavy rules, which means the plan cannot provide benefits to just the key, highly compensated employees. A plan in which 60% of the benefits go to key employees is a plan that shows signs of being "top-heavy," and will need to adjust things or deal with tax problems.
For-profit companies offer 401(k) plans to their employees. Non-profit organizations such as schools and hospitals offer 403(b) plans to their employees. As with a 401(k) plan, the employee indicates how much of her paycheck should go into the 403(b) account, which simultaneously gives her a tax break now and helps her save up for retirement later. As with a 401(k) plan, the contributions go in pre-tax but come out taxable when the participant starts taking distributions.
While a 401(k) plan might offer participants the ability to purchase stocks and bonds a la carte, a 403(b) plan only offers annuities and mutual funds as investment vehicles. The 403(b) plans can also be referred to as Tax-Sheltered Annuities or TSAs.
Some states and cities have begun to shift the burden of funding retirement benefits to their employees. These so-called 457 plans are for state and local government employees, e.g., police and fire workers. Contributions are tax-deductible, and the plans use the same maximum contribution limits used by 401(k) and 403(b) plans.
Profit sharing plans are also defined contribution plans, but the contributions are never required. If the company does contribute, it must be made for all eligible employees based on a predetermined formula. For example, maybe all workers receive up to 10% of their salaries when the company has a banner year. The profit-sharing plan uses much higher maximum annual contributions than the 401(k), 403(b) or Section 457 plans. Of course, that would only matter if you happened to work for a profitable and generous employer.
A money purchase plan is not flexible the way a profit sharing plan is. The money purchase plan requires the employer to make a mandatory contribution to each employee's account, based on his/her salary, whether the company feels like it or not. in a money purchase plan, contributions are mandatory on the part of the employer and discretionary on the part of the employee.
Keogh plans are for individuals with self-employment income or for those working for a sole proprietorship with a Keogh plan in place. They're not for S-corps, C-corps, LLCs, etc.only sole proprietors. If the individual in the test question has side income or is self-employed, he or she can have a Keogh. They can contribute a certain percentage of their self-employment income into the Keogh.
How much? A lot. As with the SEP-IRA, the business owner can put 20% of her compensation into a Keogh, and can put in 25% of her employees' compensation.
Also, Keogh plans are for sole proprietorships only; we did not say that sole proprietorships can only have a Keogh plan. A SEP-IRA or SIMPLE IRA would also be available to a sole proprietor, for example.
A small business can establish a SEP-IRA, which stands for "Simplified Employee Pension" IRA. This allows the business owner to make pre-tax contributions for herself and any eligible employees. Twenty-five percent of wages can be contributed to an employee's SEP, up to the current maximum. SEP contributions are not mandatory on the part of the business owner. It's just that if the business makes any contributions, they must be made to all eligible employees as stipulated in the plan agreement. Same as for a profit sharing plan.
Also like a profit sharing plan, the employer makes the contributions, not the employees. So, if you're self-employed, you can contribute to your own SEP-IRA, but if you're an employee at a company with a SEP-IRA, it's the company who will make the contributions on your behalf. To establish a SEP, the employer uses a model agreement put out by the IRS (download it from www.irs.gov) that they and the employees sign. It does not have to be filed with the IRS, which does not issue an opinion or approval.
A SIMPLE plan can be either an IRA or a 401(k). The SIMPLE plan is for businesses with no more than 100 employees and with no other retirement plan offered. In a SIMPLE plan, business owners choose to either match the employee's contributions up to 3% of compensation, or to contribute 2% of the employee's compensation if he does not make an elective deferral from his paycheck. A SIMPLE plan is ideal at a small company where, say, only 3 of 12 employees want to put money away for retirement. When the other 9 make no elective deferrals, the employer makes no matching contributions. And for the three who do choose to invest part of their paychecks, the company matches the elective deferrals up to just 2% of compensation. That means for an employee earning $40,000, the employer's matching contributions would stop at $800.
Unlike with a 401(k) plan, employees are immediately vested in a SEP-IRA or SIMPLE plan. That means the employer's contributions belong to the employee as soon as they are made.
Many companies reward key employees by offering them employee stock options. These options do not trade among investors but are essentially free call options that allow employees to buy the company's stock at a set strike/exercise price. To keep the employee around a while, the company usually awards the options to buy the stock on a vesting schedule by which the employee gradually receives options. An ESOP or employee stock ownership plan is what it sounds like. Through these plans the company allows all workers to purchase company stock at a discount and through a payroll deduction. The stock and the dividends/cap gains generated on it grow tax-deferred, like a 401(k) plan.
Defined Benefit Plans
Defined benefit pension plans are the opposite of defined contribution plans. In a defined contribution plan the employer puts in some money and then wishes employees the best of luck with retirement. For a defined benefit plan, the employer bears all the risk and, therefore, must earn sufficient returns on their investments to pay a defined benefit to retirees and their survivors.
Maybe that defined benefit is 70% of average salary figured over the employee's last three years of service, paid out each year in retirement, plus maybe a benefit to a spouse or children if he dies within a certain time.
A defined benefit pension plan is established as a trust and does not pay tax on the income it generates. In fact, the company gets to deduct the contributions it makes into the pension fund from taxable income. Therefore, these plans do not typically in¬vest in municipal securities, since they are already tax-advantaged accounts.
Because corporations typically try to fund these plans only as much as required, defined benefit plans require an actuary to certify that funding levels are sufficient to cover future pension fund obligations.
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