A defined contribution plan is retirement plan that does not promise a specific amount of benefits at retirement.
In fact on these plans, the employee or the employer or both contribute to the employeeâ€™s individual account under the plan, sometimes at a set rate of return, for example, a 7 or 8 percent of earnings annually.
The employee has an option of investing this intoÂ various types of investment assets such as cash equivalents, fixed income funds (a.k.a. bonds), or stock mutual funds.
One of the biggest disadvantage of most employer defined contribution plans is that the employees are pretty much limited to the mutual fund or stock funds Â selected by their employer. Â However, some employers actually provide flexibility on the plan where employees are given option for self-directed investments. This is usually available for employees who are knowledgeable with stock investments.
The Employer Retirement Plans
The 401(k) plan is the most common plan established by employers. I’m sure that you’re curious about the name as the name was derived from the 401(k) section of the IRS tax code.
The way it works is that employees can elect to defer receiving a portion of their salary in order to contribute it to the 401(k) retirement plan. Â These contributions are tax deferred, meaning that these are excluded from your current taxable income but would be eventually taxable once you start withdrawing your funds.
Like most plans, the biggest advantage is your money grows faster because you are able to re-invest money that would otherwise be paid to taxes.
In most cases, the employer matches these contributions as an incentive for the employee to participate in the plan. For example, assuming that employers matches up to 4% of your salary, you can contribute $200 from your $5,000 monthly salary and the employer will add $200 towards your plan as well. It’s like earning 100% before you even invest it!
Please keep in mind that 401k plans have dollar limitations on how much you can contribute each year For 2010 and 2011, the limit is $16,500 annually for the total contribution (employee and matching). One last thing to remember is that employees who participate in 401(k) plans assume responsibility for their retirement income by allocating their own funds to various investment choices, which usually depends on whatever mutual fund companies your employer selected.
In some cases, you Â may be able to utilize the self-directed feature where it allows you to invest it outside of your employer’s selected funds depending on your plan provisions.
Simplified Employee Pension Plan (SEP)
SEP is a relatively uncomplicated retirement savings vehicles because it is subject to minimal reporting and disclosure requirement as compared to any other plans. Another difference between this plan and the 401k plan is that in a 401k, the contributions has to go through the company trust funds while this plan can be invested in your own individual retirement account (IRA).
Under a SEP, you must set up an IRA to accept the employer’s contributions. Although, employers may no longer set up Salary Reduction SEPs, they are allowed to establish SIMPLE IRA plans with salary reduction contributions. If an employer had a salary reduction SEP, the employer may continue to allow salary reduction contributions to the plan.
Profit Sharing Plan or Stock Bonus Plan
A Profit Sharing Plan or Stock Bonus Plan is a defined contribution plan under which the plan may provide, or the employer may determine, annually, how much will be contributed to the plan (out of profits or otherwise).
One disadvantage of this plan is you do not have any control as to how much contributions will be applied to your retirement. It is usually based on aÂ Â Â formula to determine the proper allocation of a portion of each annual contribution to each participant.
For example, the employer has the flexibility to contribute 0% and 25% of eligible compensation to a maximum per year. I had this plan with my first employer and I did not get much but it is nice that I am getting something from them but I would rather have the 401(k) with matching contributions.
Employee Stock Ownership Plan (ESOP)
ESOP is a form of defined contribution plan in which the investments are primarily in employer stock. It is similar to the profit sharing plan where a company establishes a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares.
Consequently, the shares in the ESOP plan are allocated to individual employee accounts and are allocated on the basis of relative pay or some established formula.
As the number of years the employee works with the company increases, the employees become vested, which means that they increases their right to the shares in their account.
Money Purchase Pension Plan
A Money purchase pension plan is a defined contribution plan that requires fixed annual contributions from the employer to the employee’s individual account. Because a money purchase pension plan requires these regular contributions, the plan is subject to certain funding and other rules.
Cash Balance Plan
A Cash Balance Plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance.
In a typical cash balance plan, a participant’s account is credited each year with a “pay credit” (such as 5 percent of compensation from his or her employer) and an “interest credit” (either a fixed rate or a variable rate that is linked to an index such as the one-year Treasury bill rate). Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer.
When a participant becomes entitled to receive benefits under a cash balance plan, the benefits that are received are defined in terms of an account balance.
The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected, within certain limitations, by federal insurance provided through theÂ Pension Benefit Guaranty Corporation (PBGC)
Two defined contribution plan (457 and 403 (b)) are discussed in detail on this article:Â Defined contribution plans for the government employees.