A Defined Contribution Plan provides an individual account for each participant in the plan. It provides benefits to a participant largely based on the amount of contributed to that participant's account. Benefits are also affected by any income, expenses, gains, losses, and forfeitures allocated to each participant's account.

A defined contribution plan can be either a Profit Sharing Plan or a Money Purchase Pension Plan. There are several types of profit sharing plans as described below.

A Profit Sharing Plan is a defined contribution plan in which the company agrees to make "substantial and recurring" contributions on a discretionary basis. A profit sharing plan is a plan for sharing your business profits with your employees. However, you do not have to make contributions out of net profits to have a profit sharing plan. The employer decides how much or how little to contribution each year, based on the profitability of the company.

The plan must provide a definite formula for allocating contributions among participants and provide for disbursing the accumulated funds to the employees after they reach a certain age, after a fixed number of years, or upon certain other occurrences.

Separate account balances are maintained for each eligible employee. The employee's account grows through employer contributions and investment earnings. Some plans may also permit employees to make contributions on a before-and/or after-tax basis.

The participant's retirement, death or disability benefit is based upon the amount in his or her account at the time the distribution is payable.

A profit sharing plan clearly favors employers with unpredictable earnings, since employer contributions to these plans are discretionary rather than required. If your company wants to control critical plan features like employee eligibility and vesting, you might consider sponsoring a profit sharing plan.

Also, non-vested account balances which have been forfeited by terminated employees may be redistributed to the accounts of remaining participants or be used to reduce the employer's future contributions. In addition, provisions for loans and hardship withdrawals may also be included in the design of the plan.

401(k) Profit Sharing Plan

A 401(k) Plan is a special type of profit sharing plan that is flexible, cost effective, and enormously popular. A 401(k) plan can work for a large, medium, or small-sized company or professional service firm. Like a traditional profit sharing plan, a 401(k) plan offers flexible and fully tax deductible employer contributions together with tax deferred growth of plan assets. It offers employees an election to make pre-tax contributions to the plan by deferring some of their compensation into the plan through payroll deductions. The contributions and investment earnings grow tax-free until distribution. Participation by employees is voluntary.

Generally, employers do not need to make contributions to the plan. However, to encourage employee participation, a matching contribution feature may be added to the plan. The amount the employer contributes on behalf of each employee is determined on the amount that the employee elects to contribute to the plan. The employer may also declare a discretionary profit sharing contribution.

Maximum plan and individual contribution limits apply. Contributions to a 401(k) plan and all other profit sharing plans of an employer may not exceed 25% of total combined participant compensation. Elective deferrals by an individual employee are limited to an annual maximum of $13,000 in 2004 ($14,000 in 2005 and $15,000 in 2006).

A 401(k) plan is subject to an annual non-discrimination testing requirement. Under a 401(k) plan, there is a limit on how much the group of employees referred to as "highly compensated" can defer based upon the amount deferred by the "non-highly compensated" employees. A highly compensated employee is defined as a 5% owner (directly or indirectly) and/or a participant who earns more than a certain dollar amount ($90,000 in 2004). A non-highly compensated employee is simply any eligible employee who is not a highly-compensated employee.

A 401(k) plan can be quite simple, if the proper care is taken during the plan design process. Factors affecting plan complexity include the basic plan design, the number of investment options offered to employees, and optional features such as participant loan and hardship withdrawal provisions. The key to the design of a 401(k) plan is meeting the needs of the specific company and its employees, without making the plan any more complicated than necessary.

Positive employee communication and high quality, specialized administrative support is needed for a 401(k) plan to run smoothly. If your 401(k) plan is clearly and positively introduced to your employees, they will value the plan and actively participate.

Safe Harbor 401(k) Plan

A Safe Harbor 401(k) Plan is a special type of 401(k) Plan that eliminates the non-discrimination testing otherwise required of traditional 401(k) plans. Thus, each plan participant (whether highly-compensated or non-highly compensated) may defer a portion of his or her salary up to the IRS imposed maximum limitation ($13,000 for 2004, $14,000 for 2005 and $15,000 for 2006).

Under a Safe Harbor 401(k) Plan, an employer is required to provide either a safe harbor non-elective contribution or provide for a matching contribution based upon the prescribed safe harbor contribution formula.

The safe harbor non-elective contribution must be equal to at least 3% of eligible compensation and is made to all eligible employees.

Alternatively, the employer could elect to provide a matching contribution on the 401(k) salary deferrals of each eligible participant based on the following formula:

1. On a dollar-for-dollar basis on the first 3% of salary deferred, plus
2. An additional fifty cents on the dollar basis on the next 2% of salary deferred.

Assuming that a participant defers 5% of his or her salary, the maximum matching contribution allocation would be equal to 4% of his or her compensation. The matching contribution is only allocated to those employees who elect to defer a portion of his or her salary to the plan.

Note that under either safe harbor contribution method, each participant is immediately 100% vested in these contributions. Further note that restrictions cannot be placed on the eligibility for these types of contributions such as a last day of the year requirement or a 1000 hours worked requirement. Once a participant has met the specific eligibility requirements to participate in the plan, they become automatically eligible to receive any safe harbor contribution allocation.

Cross-Tested or "New Comparability" Plan

A Cross-Tested or "New Comparability" Plan is a special type of profit sharing plan. Under this type of plan, an employer may divide employees into separate and distinct allocation groups in order to provide larger percentage contributions for certain select employees than for other employees.

By using the allocation group technique, a plan can be designed to provide one contribution rate to a select group of employees, with a different and much lower rate for employees who are not in the select group(s).

The allocation groups may be based on any reasonable criteria, including percentage of ownership, status as key or highly-compensated employee, job description, length of service, age, etc. The allocation groups can be tailored to satisfy specific objectives since they can be set up for owners, officers, supervisors, managers, long-service employees, or salaried employees.

The structure of the allocation groups must be defined in the plan document and may be changed periodically by plan amendment. Each allocation group has its own allocation method. Within each allocation group, the contribution is allocated uniformly (either as a flat dollar amount or as a percentage of pay). The annual allocation method must also be defined in the plan document and may be changed by plan amendment, provided no individual's accrued benefit is reduced.

New Comparability Plans usually require annual testing and are somewhat sensitive to employee demographics. However, in many situations, a New Comparability Plan offers tremendous opportunities for the business owners.

Age-Weighted Profit Sharing Plan

An Age-Weighted Profit Sharing Plan resembles a traditional profit sharing plan with one important exception: the way the employer contribution is allocated to each participant's account.

An age-weighted plan allocates employer contributions based on age in an attempt to provide an assumed equivalent retirement benefit at normal retirement age. Unlike a typical profit-sharing plan in which each participant receives a contribution based on compensation, employees in age-weighted profit-sharing plans have an age factor applied to the profit-sharing plan allocation formula in order to compensate older employees who have fewer years to accumulate sufficient funds for retirement.

At first glance, this type of formula might appear to violate nondiscrimination regulations, since it permits larger contributions for older employees, who tend to receive higher compensation. However, under the regulations, these contributions can be converted to "equivalent benefits" and can pass the general non-discrimination test. Since annual allocations are projected to retirement age with interest, they will vary according to the ages of the plan participants. All of the basic requirements that apply to a traditional profit-sharing plan also apply to an age-weighted profit sharing plan.

Money Purchase Pension Plan

A Money Purchase Pension Plan is a defined contribution plan where the employer is required to make an annual contribution on behalf of all eligible employees, regardless of the profitability of the company. Contributions to a money purchase pension plan are fixed according to the plan's document and are not based on your business profits. In general, a pension plan must satisfy the minimum funding standard for each year.

If your business is consistently profitable and you are an employer who wants to reward key employees with a generous retirement benefit; or if you are a self-employed individual who would like to tax-shelter as much income as possible, then you should consider sponsoring a money purchase pension plan.

Unlike a profit sharing plan where employer contributions are optional, employer contributions under a money purchase pension plan are mandatory and the employer contributes a fixed amount or a fixed percentage of compensation on an annual basis. Changing the contribution requires a plan amendment which the IRS will only allow if the change is infrequent.

Similar to profit sharing plans, money purchase pension plans may allow the exclusion of some employees by using eligibility criteria and gives the employer a greater degree of control in determining when employees are vested.

A Defined Benefit Plan is any qualified retirement plan that is not a defined contribution plan. Contributions to a defined benefit plan are based on what is needed to provide definitely determinable benefits to plan participants. Actuarial assumptions and computations are required to figure the annual contribution requirements.

The defined benefit plan defines and promises a specific benefit at some point in the future. This defined benefit is provided typically at the retirement of the employee participant. For example, a typical benefit may be a monthly income starting at age 65 equal to 50% of the employee's average salary over the last three years of work.

The employer is required to contribute, and may deduct, whatever amount is actuarially necessary to assure the benefit is funded, which places the investment risk with the employer, not the participant. If the investments do not perform as projected, the employer may have to contribute more to the plan in the future.

Because benefit accrual tends to reward long-term service, and because with older employees there is less time for assets to accumulate to fund the benefit, contributions for older employees generally are much higher than younger employees. Thus, older business owners, seeking large contributions often favor defined benefit plans.

For aging management groups who have little chance to save for retirement, a defined benefit plan is an excellent way to make up for lost time. A defined benefit plan provides the only way for companies to make annual tax-deductible contributions for their employees in excess of $41,000 or 100% of pay (the maximum for defined contribution plans).

Because of the required funding costs, and potential growing funding liability for older employees, the number of defined benefit plans has dropped over the past decade. As the baby boom of employees is growing older and becoming more transient in employment, larger employers have steered away from defined benefit plans to employee participatory plans such as 401(k) plans.

However, recent tax law changes have allowed defined benefit plans to regain some popularity. Medical groups, law firms, and closely-held businesses are often candidates for a Defined Benefits Plan.