Defined Contribution Plans

Defined contribution plans, which are less expensive and more flexible than defined benefit plans, are actually a broad range of programs including profit-sharing plans, money-purchase plans, 401(k) plans, and others. Either you alone, or you and your employee 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. Each employee's benefits depend on how much was contributed in his or her 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 your name each year no matter how many different plans you participate in. The total amount that can be contributed in one employee's name in 2002 and 2003 is the lesser of $40,000 or 100 percent of the employee's annual earnings. Contributions by self-employed persons are treated like those made on behalf of employees, except the tax deductions may be more limited.

The contributions are allocated to separate accounts for each participant based on a definite, predetermined formula. Forfeitures can be reallocated to remaining participants.

Profit-sharing plans. Profit-sharing plans continue to be a popular type of plan, especially for small businesses. They offer a great deal of 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.

In 2002 and 2003, the employer has the discretion to contribute up to the lesser of $40,000 or 25 percent of compensation for each plan participant. For yourself as the employer, however, the applicable percentage limit is only 20 percent of your net earnings. The employer may decide not to contribute in any given year, if it so desires.

Money-purchase plans. In a money-purchase plan, the employer is obligated to contribute each year 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. In 2002 and 2003, the employer may contribute up to the lesser of $40,000 or 100 percent of each employee's compensation. You, as the business owner, may contribute and take a tax deduction in 2002 for the lesser of $40,000 or 20 percent of your net earnings.

401(k) plans. Many qualified defined contribution plans permit participating employees to make contributions to a plan, so they can 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 the employees' 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' own contributions must be nonforfeitable.

The employee's elective deferral to all 401(k) plans is limited to $11,000 in 2002 (increasing $1,000 every year through 2006). The employer's 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, 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.

Save Money While 401(k) plans are popular with large corporate employers, they are not the most popular plans for small business owners since they severely limit the amount of money a business owner can sock away on his own behalf. If you're going to the trouble and expense of setting up a pension plan, a money purchase plan would generally offer you more flexibility and the opportunity to defer tax on a much larger nest egg.