Defined-Contribution Plans
Employers have become less generous than they had been in the past with
pension benefits. Corporate restructurings have left many people working for
smaller businesses which usually don't offer generous pensions. Many big
established companies have changed from, or rely less on, the more costly
defined-benefit plans. Instead, many companies now use the less expensive and
more flexible defined-contribution plans.
Defined contribution plans are actually a broad range of programs including
profit-sharing plans, money-purchase plans, 401(k) plans, employee stock
ownership (ESOP) plans and others. Either you alone, or you and your employer
make contributions into the plan, usually based on a percentage of your 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. Your
benefits depend on how much was contributed in your 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
for 2002 is the lesser of $40,000 ($35,000 for 2001) or 100 percent of the
employee's annual earnings (25 percent for 2001). 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 are now the most popular type of plan,
especially for small businesses. They offer the greatest 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. Generally, the
employer has the discretion to contribute up to 25 percent of compensation
for 2002 (15 percent for 2001) for all participants in the plan. The
employer may decide not to contribute in any given year, if it so
desires.
- Money-purchase plans: in the money-purchase plans, the employer is
obligated to contribute 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.
- 401(k)
plans: many qualified defined-contribution plans permit participating
employees to make contributions to a plan on a before-tax basis. These plans
are called cash or deferred arrangements or CODAs (or, more popularly, a
401(k) plan, named after the Internal Revenue Code provision dealing with
CODAs). They enable participants to 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 these employee 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'
contributions must be nonforfeitable. The employee's elective deferral to
all 401(k) plans is limited to $11,000 for 2002 ($10,500 for 2001; this
amount may be adjusted periodically for inflation). Those who are age 50 and
over in 2002, can contribute an additional $1,000 for the year. The employer
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.
- Employee Stock Ownership Plans (ESOP): an ESOP is a stock bonus
plan or a combination stock bonus plan and money purchase plan that is
designed to invest primarily in qualifying employer securities and to use
borrowed fund to do so. An ESOP is funded by employer contributions of stock
in the corporation or allows you to buy shares of stock as a plan investment
option. ESOPs must comply with all the requirements imposed on other types
of defined-contributions plans. ESOPs cannot be integrated with social
security.
Other examples of defined contribution plans for small businesses to consider
include:
- SIMPLE
plans
- SEPs
(simplified employee pensions)
- SARSEPs
(salary reduction simplified employee pensions: these plans may no longer be
started, but an existing SARSEP plan may be continued)