Plan descriptions

Defined Contribution Plan:

These plans define the contribution a company will make to the plan and how the contribution will be allocated among eligible employees. An employee’s account grows through employer contributions, investment earnings and, in some cases, forfeitures—funds invested into the plan that come from the non-vested accounts of terminated employees. Some defined contribution plans may also permit employees to make contributions on a before- and/or after-tax basis.

In a defined contribution plan, the contributions, investment results and forfeiture allocations vary year-to-year. As a result, the ultimate retirement benefit cannot be predicted. An employee's retirement, death or disability benefit is based upon the amount in his account at the time distribution is paid.

The portion of an employee’s account balance resulting from employer contributions may be subject to a vesting schedule. Non-vested account balances forfeited by terminated employees can be used to reduce employer contributions or can be reallocated to active participants.

In 2013, the maximum annual amount that can be credited to an employee’s account, taking into consideration all defined contribution plans sponsored by the employer, is limited to either 25 percent of compensation or $51,000, whichever is the lesser amount.

401(k)—a type of Defined Contribution Plan:

Employees perceive 401(k) plans as a valuable benefit; consequently, they are the most popular retirement plan available today. And employees benefit from a 401(k) plan even if the employer makes no contribution. In this plan, employees elect to make pre-tax contributions through payroll deduction up to the annual maximum limits allowed by law. In 2013, this maximum is $17,500. Employees who are age 50 and older are eligible to defer an additional $5,500 (subject to change), a benefit referred to as a “catch-up” contribution.

In a 401(k) plan, employers will often match some portion of the amount deferred by the employee in order to encourage greater employee participation. For example, an employer might offer a 25 percent match of the first 4 percent deferred by the plan participant. Because a 401(k) is a type of profit sharing plan, profit sharing contributions may be made in addition to or instead of matching contributions. Many employers offer participants the opportunity to borrow from the plan or take hardship withdrawals.

Laws governing 401(k) plans subject employer and employee matching contributions to a nondiscrimination test. These laws are designed to limit the dollar amount deferred by the group that qualifies as “highly compensated employees” based on the amount deferred by the “non-highly compensated employees” group. It is possible to eliminate this nondiscrimination test by ensuring the plan satisfies 401(k) “Safe Harbor” requirements.

Profit Sharing—a type of Defined Contribution Plan:

A profit sharing plan is one of the most flexible qualified plans available. Company contributions to this plan are usually made on a discretionary basis, with the employer deciding the amount, if any, it will contribute on an annual basis. For tax deduction purposes, company contributions cannot exceed 15 percent of the total compensation of all eligible employees. The current contribution limit is 25 percent of each individual employee's compensation.

A company’s contribution to a profit sharing plan is usually allocated in proportion to employee compensation and may be integrated with Social Security benefits. Consequently, higher-paid employees receive larger company contributions (within limits set by the IRS).

In an age-weighted profit sharing plan, the contribution formula takes into consideration both the employee’s compensation rate and age. As a result, a significantly larger portion of the contribution goes to those employees closer to retirement age.

Money Purchase—a type of Defined Contribution Plan:

This plan operates like a profit sharing plan, with one significant difference: the employer has a set contribution rate. The employer’s mandatory contributions are made annually, regardless of company profits or losses. Failure to make a contribution can result in penalties.

In general, employee contributions to this plan are a fixed percentage of compensation. For tax-deduction purposes, the company’s contribution cannot exceed 25 percent of compensation and is limited to a specific dollar amount (see theAnnual Plan Limits chart in the Resources section).

A money purchase plan allows integration of Social Security benefits, which results in larger contributions for higher-paid employees.

New Comparability—a type of Defined Contribution Plan:

Sometimes referred to as a “cross-tested” plan, a new comparability plan is like a profit sharing or money purchase pension plan in that it is tested for nondiscrimination. As a result, certain employees may receive much higher allocations than would be permitted by defined contribution nondiscrimination testing.

New comparability plans are generally used by small businesses that want to maximize contributions to owners and higher-paid employees while minimizing contributions to all other participants.

In this plan, employees are separated into two or more identifiable groups—for example, owners and non-owners—and each group may receive a different contribution percentage. This is allowable, as long as the plan satisfies nondiscrimination requirements.

ESOP—a type of Defined Contribution Plan:

ESOP—a type of Defined Contribution Plan: A type of profit sharing plan, an ESOP is required to invest primarily in the employer’s stock. Although the rules governing an ESOP differ from those that apply to a profit sharing plan, the general principles are the same.

As its name implies, an ESOP offers employees an ownership stake in the company. As owners, employees may be motivated to improve overall company performance because they benefit directly from its profitability.

Defined Benefit Plan:

Defined benefit plans, often referred to as “pension” plans, are the original type of retirement plan. A defined benefit plan includes a specific formula for calculating the retirement benefit or “pension” a participant will receive at retirement age for the remainder of their life. The benefit is often expressed as a function of a participant’s average annual compensation while working and their years of service. This benefit is a promise to the participant and therefore, the employer must make annual contributions to the plan to fund the benefit regardless of the employer’s financial situation.

Cash Balance—a type of Defined Benefit Plan:

A cash balance plan is a "hybrid" plan. Technically, a cash balance plan is a defined benefit plan, but one that looks like a profit sharing plan where the plan benefits are expressed as participant account balances vs. a benefit at retirement age. Cash balance plans first appeared around 1985 as a concept to address the changing demographics of the workforce. In 2001, favorable increases were made to the funding limits, and in 2006 cash balance plans were cleared from being age discriminatory.

Each year you are required to fund the plan according to defined benefit funding rules. The funds are pooled and will generally equal a little more than the total hypothetical account balance. However, unlike a standard defined benefit plan, each participant in a cash balance plan will have their own account balance that is tracked and grows year-to-year separate from other participants' accounts.

Cash balance plans can be combined with a profit sharing or 401(k) plan to maximize tax savings and contributions can be strategically allocated to benefit yourself, other business owners and/or tenured employees while allowing greater flexibility in year-to-year contributions than a standalone defined benefit plan. In short, if your business generates strong and steady profits, a cash balance plan (with or without a combo plan) could be your most effective tool in maximizing retirement savings for you and your key business stakeholders.