Defined Contribution Plans

A defined contribution plan establishes an individual account for each participant, with benefits primarily determined by the contributions made to that participant’s account. These benefits are influenced by various factors, including income, expenses, gains, losses, and forfeitures from other accounts that may be assigned to an account. Such plans can take the form of either profit-sharing plans or money-purchase pension plans.

Despite its name, a “profit-sharing plan” doesn’t necessitate that the taxpayer generates a profit for the year to contribute. Instead, it can allow for discretionary employer contributions, meaning the contribution amount to the plan is not fixed and can even be zero for a given year. However, a profit-sharing plan must delineate a clear formula for distributing the contribution among participants and for disbursing the accumulated funds to employees upon reaching a certain age, after a specific number of years, or under other specified circumstances.

In a money purchase pension plan, contributions are predetermined and do not hinge on the business profits of the taxpayer. For instance, if the plan mandates contributions equivalent to 10% of participants’ compensation, irrespective of the taxpayer’s profitability (or the earned income of a self-employed individual), it qualifies as a money purchase pension plan. This classification remains valid even if the compensation of a self-employed individual participating in the plan is derived from the business profits.

It’s widely acknowledged that defined benefit plans are notably intricate and often more costly to manage compared to many other types of qualified employee plans. Conversely, defined contribution plans typically offer a simpler alternative. Unlike defined benefit plans, defined contribution plans typically don’t necessitate actuarial calculations to ascertain contributions for individual participants, nor do they offer a predetermined benefit from the plan. Instead, these plans are structured around the employer’s contributions, without specifying a guaranteed benefit for participants.

Various plans fall under the umbrella of defined contribution, including:

• Target benefit plans
• Profit-sharing plans
• Thrift plans
• 401(k) plans
• 403(b) tax-sheltered annuity plans
• Stock bonus plans
• Employee stock ownership plans (ESOPs)
• Simplified employee pensions (SEPs)
• Savings incentive match plans for employees (SIMPLEs)

Unlike defined benefit plans, where contributions are determined by the retirement benefit promised, defined contribution plans require contributions according to the plan’s formula, typically based on the participant’s compensation. For instance, a defined contribution plan might specify that the employer must contribute 10% of a participant’s compensation. Consequently, the eventual retirement benefit provided by the plan is contingent upon the value of the participant’s account balance at retirement. For instance, if a participant’s account balance is $500,000 at retirement and they opt for a monthly benefit, it might amount to $4,000; however, if the account balance is $625,000, the benefit could increase to $5,000 a month.
In defined contribution plans, the retirement benefit is primarily influenced by the performance of the plan’s assets, placing the investment risk squarely on the participant’s shoulders rather than the employer’s. Given the inherent uncertainty surrounding future investment performance, the precise retirement benefit in a defined contribution plan remains unpredictable.
Moreover, in certain profit-sharing plan setups where employers have the flexibility to make discretionary contributions, the future level of contributions also remains uncertain. In these types of defined contribution plans where contributions are discretionary, attempting to estimate the eventual retirement benefit becomes an exercise in futility.

Participants in defined contribution plans often have the opportunity to manage the investment of their own plan account balances. A prominent instance of this arrangement is the 401(k) plan, where participants are empowered to allocate their elective deferrals and matching employer contributions across a diverse array of investment options. Irrespective of whether the responsibility for directing individual account investments lies with the participant or another designated entity, the ultimate benefit for defined contribution plan participants can exceed expectations when plan investments perform favorably. Conversely, if investments perform below expectations, the eventual plan benefits may fall short of anticipated levels.