DEFINED CONTRIBUTION PLANS
A Defined Contribution Plan is a type of plan where both employers and employees contribute to a participant’s individual account on a regular basis. Upon retirement, a participant’s account consists of these contributions plus earnings, including interest and returns on investment from stocks, bonds, etc. The participant can choose to make a direct roll over of the funds in his account to another qualified vehicle to delay paying taxes on the money, take the money and pay the taxes or purchase an annuity and turn it into a monthly benefit guaranteed for life.
Profit Sharing Plans
This is a plan in which an employer determines how much of the company’s profit, if any, will be allocated among the participants based on the ratio of a participant’s compensation to the total compensation of all the participants.
The Profit Sharing amount was determined by the employer to be $15,000.
Lombardo’s Music Store has five employees with the following compensation:
- Employee 1 – $20,000
- Employee 2 – $25,000
- Employee 3 – $18,000
- Employee 4 – $30,000
- Employee 5 – $32,000
He’s now going to allocate the Profit Sharing amount based on the ratio as mentioned above.
Employee 1: $20,000 / $125,000 = .16
$15,000 x .16 = $2,400 – Employee 1’s Profit Sharing Allocation
Employee 2: $25,000 / $125,000 = .2
$15,000 x .2 = $3,000 – Employee 2’s Profit Sharing Allocation
Employee 3: $18,000 / $125,000 = .144
$15,000 x .144 = $2,160 – Employee 3’s Profit Sharing Allocation
Employee 4: $30,000 / $125,000 = .24
$15,000 x .24 = $3,600 – Employee 4’s Profit Sharing Allocation
Employee 5: $32,000 / $125,000 = .256
$15,000 x .256 = $3,840 – Employee 5’s Profit Sharing Allocation
Total: $2,400 + $3,000 + $2,160 + $3,600 + $3,840 = $15,000
This is the most common method of allocating the profits in this type of plan.
Money Purchase Plans
This is a plan where the contribution is a fixed amount each year based on a percentage of the compensation of all the participants.
Lombardo’s Music Store has a Money Purchase Plan with a contribution of 8% of the participants’ compensation. Each participant’s Money Purchase contribution is calculated simply by multiplying their compensation by 8%.
- Employee 1 – $20,000 x .08 = $1,600
- Employee 2 – $25,000 x .08 = $2,000
- Employee 3 – $18,000 x .08 = $1,440
- Employee 4 – $30,000 x .08 = $2,400
- Employee 5 – $35,000 x .08 = $2,800
Both Money Purchase and Profit Sharing Plans may allow for employee contributions, depending on the elections made by the employer when setting up the plan.
This is the plan used most often today. This type of plan was intially introduced during the 1980’s as taking much of the burden of funding employees’ retirement funds off the employer. Participants make pre-tax contributions (also know as Elective Deferrals, Salary Deferrals, Salary Elective Deferrals, 401(k) Contributions). Therefore, federal income tax withheld from a participant’s salary on is calculated on the amount of his salary minus his Elective Deferrals.
Sal Minella earns $600 per week. His Elective Deferrals are 3% of his pay; in this case $18. Therefore, the federal income tax withheld from his pay is $600 minus $18 or $582. The taxes on that $18 and all other Elective Deferrals made, during his tenure with the employer, are deferred until retirement when the participant takes distribution of his 401(k) account.
There are limits to the amount a participant may defer per year. For 2018, that limit was $18,000.
Employers can set up the plan to allow for Employer Matching Contributions. During my career in the retirement plans business, I’ve seen various Employer Matching Contribution provisions included in these plans. It should be noted that I worked mostly on plans that consisted of one thousand or less employees. Examples of the main ones, at least the most common ones, are as follows:
The employer will make Employer Matching Contributions equal to 100% up to 3% of the participant’s compensation. However, if a participant only elects to defer 2% of his pay, then the Employer Match will only be 2%
The employer will make Employer Matching Contributions equal to 50% up to 6% of the participant’s compensation.
There will be no Employer Matching Contributions to the plan.
IMPORTANT: all employee contributions to the plan are 100% vested right from the get-go. When you contribute to any retirement plan, your contributions are not subject to the vesting schedule. Employer Matching Contributions are subject to the vesting schedule.
Maximize The Investment In Your 401(k) Plan
401(k) Plans were designed to put the burden of accumulating wealth for your retirement on you, and greatly ease the burden for the employer. As a result, it is recommended that you take advantage of the plan provisions that maximize this accumulation.
Let’s take our friend, Sal Minella, for this exercise. As noted above, Sal makes $600 per week. In the case of Example 1, Sal could contribute the full 3% of his pay each week to his 401(k) account. As a result, the employer would be contributing 3% to his Employer Matching Account. In essence, Sal is making 100% interest on his 401(k) Contributions on top of the earnings both accounts are accruing through the vehicles into which these funds are invested.
Many 401(k) plans also include a provision that allows the participants to also make post-tax voluntary contributions. This is an option you should use to further increase your account balance.
In Example 2, Sal would have to make 401(k) contributions in the amount of 6% of his pay in order to get 3% of his compensation matched.
In Example 3, it’s obvious your employer is a cheapskate so you might want to look elsewhere for a job.
And, by the way, your accounts are earning interest and/or dividends.
You usually earn interest on the portion of your account that is deposited into a fixed-interest fund.
With regard to stocks, mutual funds, etc, (any investment vehicles that is valued on a daily basis) those earnings are known as “Unrealized Appreciation” or “Unrealized Depreciation”. Unrealized means that you have yet to take distribution of your funds; they have yet to be liquidated. Appreciated means that as of the end of the plan year, your investment made money and, of course Depreciation means your account lost money.
Today, you will find very few Profit Sharing Plans and fewer Money Purchase Plans. The trend for the past two decades has been the 401(k) plan.