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Defined contribution plans, which are less expensive and more flexible than defined benefit plans, are actually a broad range of programs including profit-sharing plans, money-purchase plans, 401(k) plans, and others. Either you alone, or you and your employee make contributions into the plan, usually based on a percentage of the employee's 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. Each employee's benefits depend on how much was contributed in his or her name and how well the pension fund investments performed. So, the risk of fluctuations in investment return is shifted to the employees.
Contribution limits. The government sets a limit on how much can be contributed per participant each year no matter how many different plans you participate in. The total annual amount that can be contributed in one employee's name in 2011 is the lesser of $49,000 or 100 percent of compensation.(This amount increases to $50,000 in 2012.) The limit increases to $54,500 for participants age 50 or older in 2011 ($55,500 in 2012).
Contributions are allocated to separate accounts for each participant based on a definite, predetermined formula. Contributions by self-employed persons are treated like those made on behalf of employees, except the tax deductions may be limited. 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. In 2011, the employer has the discretion to contribute annually up to the lesser of $49,000 or 25 percent of compensation for each plan participant. (This amount increases to $50,000 in 2012.) For yourself as the employer, however, the applicable percentage limit is only 20 percent of your net earnings. The employer may decide not to contribute in any given year, if it so desires.
Money-purchase plans. In a money-purchase plan, the employer is obligated to contribute each year even if the company didn't make a profit. This factor alone reduces their popularity. 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, so they can 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 the employees' 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' own contributions must be nonforfeitable.
The employee's annual elective deferral to all 401(k) plans is limited to $16,500 for 2011 ($17,000 in 2012.) Also, 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.