Defined Contribution Plans
A defined contribution plan does not promise a specified amount in retirement like a defined benefit plan does. Instead, the employee, the employer, or both contributes to the employee’s individual account under the plan, sometimes at a set rate percentage, and then invest those contributions on the employee’s behalf. The end balance of the defined contribution plan will be affected by the changes in value of the retirement investments.
The most common retirement insurance plan, the 401k plan, is a defined contribution plan, as are
- 401(b) plans
- Employee stock ownership plans (ESOP)
- Simplified employee pension (SEP) plans
- Profit-sharing plans
- Self-employed Keogh profit-sharing plans
How do defined contribution plans differ from one another?
Most people know the basis of a 401k plan; an employee puts away a part of their salary and puts that specified amount away in retirement investments, usually directed by their own decisions. There are constrictions as to how much money can be placed in retirement investments issued by a 401k plan along with other special rules federally governing this plan. Once that person reaches retirement, they are able to use the un-taxed money to support their retirement lifestyle.
Employee stock ownership plans are almost the same as a 401k plan except that almost all the investments are placed in the companies stocks for retirement as opposed to being spread out and chosen by the investee.
A SEP allows employees to make contributions to their retirement investments on a tax-favored basis to IRAs owned by the employees. This means an IRA must be set up first, and then the SEP can be established. Companies used to be able to develop Salary Reduction SEPs which is no longer available. However, they are allowed to set up Simple IRA plans with salary reduction contributions.
A Profit Sharing Plan, otherwise known as a Stock Bonus Plan, is a defined contribution plan where the employer annually contributes a set amount into your investments. The amount is usually based on a formula and usually includes a 401k plan.
How much can I contribute to my defined contribution plan?
The name of this plan explains it all; there is a defined amount an employee can. In 2009, according to IRS.gov, a defined contribution plans annual contributions and other additions (excluding earnings) paid to a participant’s account cannot exceed the lesser of 100% of the participants income, or $49,000.
Depending on what type of defined contribution plan you have, the defined contribution limits will change. For example, with a SEP plan you can contribute up to 25% of compensation if you’re employed by your own corporation, or up to 20% of self-employment income if your business is unincorporated. Keep in mind, the final contribution for the entire year (as of 2010) cannot exceed $49,000.
How much money will I receive at retirement?
The amount that defined contribution plans will acquire throughout your time with the plan depends on multiple factors. The main factors being:
- How much you contribute
- How soon you begin contributing
- The rate of return earned on your investments
One of the biggest pulls of defined contribution plans is that you can stop or lessen the amount of contributions you make in a year. This means in times of economic troubles, the contributions can decrease with no penalty.
