You might wonder why some plans end up classified as both defined contribution and defined benefit. This status relates to how benefits are determined, and not by the type of benefit provided. Consider a simple fringe benefit (not an ERISA plan). For example, if the employer promises to provide meals for all full-time employees without regard to the dollar cost or amount consumed, that is a defined benefit arrangement. In contrast, if the employer says that it will set aside $2,000 at the beginning of the year to cover meal costs, and the employee can choose when and how to spend it but that when it is used up, there is no more coverage, the plan would be a defined contribution arrangement.
Popular plan types
Pension plans
Defined contribution plans
Profit-sharing plans
Profit-sharing plans are defined contribution plans in that they provide individual accounts for each participant, and benefits are based on the amount contributed to the account, along with any income, gains, and forfeiture allocations less an allocated share of expenses and losses. Profit-sharing plans are distinguished from other defined contribution plans because the contribution is usually discretionary. Management or the board of the plan sponsor can choose whether or not to make a contribution in any year and the amount of such contribution. Some of these plans do include formulas for determining the contribution, but that is not required.
What is required is that the plan document include a specific formula for allocating the contribution. Some plans allocate the contribution based solely on compensation. Others use a combination of compensation and years of service. It is permissible, within limits, for these plans to allocate higher contribution rates on wages above the Social Security wage base than on wages earned below that level. Some plans employ a concept known as cross-testing or age-weighted formulas. These plans allocate different contribution rates to different employee classes. The plans may be tested for discrimination based upon the future benefit levels provided by these contributions, rather than the current contribution rate.
Even with the complexity of concepts such as cross-testing, profit-sharing plans are among the simplest of plan designs. As we cover the tax compliance issues of plans, you will note that profit-sharing plans are exempt from some of these requirements.
Stock bonus plans
These are substantially similar to profit-sharing plans. The primary difference is that they are expected to make plan distributions in employer securities; however, in recent years, even that requirement has been diluted. As such, other than employee stock ownership plans (ESOPs), you rarely see a stock bonus plan.
You may encounter a stock bonus plan as a component of an ESOP sponsored by an S Corporation. Because of a very rigorous testing rule that applies solely to these arrangements, it sometimes becomes necessary to transfer a portion of the shares out of the ESOP into another non-ESOP defined contribution plan or component within a single plan. This could include a profit-sharing, stock bonus or 401(k) plan.
401(k) plans
This is potentially the most common pension plan in today’s economy. Commonly referred to by their IRC section, 401(k) plans, also known as CODAs (cash or deferred arrangements), must be part of a profit-sharing or stock bonus plan. However, no employer contribution is required. Basically, a 401(k) arrangement allows employees to defer part of their salaries to the plan. If the contribution election is made, the employee may defer income tax on the amount until the monies are distributed in future years. The employer may make a matching contribution that goes only to those employees who are deferring, a contribution that is shared by all eligible employees, or a combination of both.
These plans are subject to more restrictions than profit-sharing or stock bonus plans that are funded solely by employer contributions.
As with all defined contribution plans, the employee bears the investment risk. In contrast, the plan sponsor or employer has a predictable benefit cost as defined by the plan design.
There are five types of contributions that can be made to a 401(k) plan, although only elective contributions are actually required. The five types are as follows:
Elective pretax contributions. Employees elect to have a portion of their compensation contributed and tax-deferred under the CODA. These contributions must be fully vested and there are restrictions on withdrawals. These are subject to a special discrimination test referred to as the average deferral percentage (ADP) test.
Voluntary after-tax contributions. These are contributions that an employee can make via payroll deductions. The contribution is subject to income tax but not the interest accrued within the plan until distributed. They must be fully vested and can be withdrawn, if the plan permits. They are subject to a similar nondiscrimination test as pretax contributions, a test referred to as the average contribution percentage (ACP) test. When withdrawn from the plan, the participant pays tax only on the earnings on these contributions.
Matching contributions. These are additional amounts based on a formula that the employer may choose for such contributions. They may be subject to deferred vesting and some restrictions on withdrawal.
Nonelective contributions. Employers may decide to make this contribution irrespective of any employee election or contribution. They are generally allocated based on employees’ salaries; but the allocation formula may take into account age, years of service, Social Security, or other nondiscriminatory factors. They may be subject to deferred vesting and the same restrictions on withdrawal as matching contributions.
Roth 401(k) contributions. Salary is contributed on an after-tax basis and neither the participant contributions nor the related earnings will be taxable upon distribution, as long as certain tax rules are satisfied. For plan operations, a Roth 401(k) contribution is treated the same as an employee elective pretax contribution, except that some kind of a separate accounting or tracking is required to recognize the distinct tax status of future distributions. Roth contributions are subject to the ADP test, just like employee elective pretax contributions. These vary from regular after-tax contributions because upon withdrawal, both the contribution and