A defined contribution plan is a qualified retirement plan that provides for periodic contributions as specified in a written formula. Contributions are made to the individual accounts (sometimes referred to as separate accounts) of participants. Defined contribution plans are also referred to as individual account plans, since each participant has a separate account in which plan contributions and investment earnings accrue. Participants receive regular statements that reflect their accrued benefits, making it possible for them to monitor the progress of their retirement benefits.
The benefits ultimately received by plan participants are not specified, but are determined by contributions, investment results (gains or losses and interest/dividend earnings), expenses, and, in some cases, amounts forfeited by participants who leave the company prior to becoming fully vested. The certainty of retirement benefits (or lack thereof) is one of the key differences between defined benefit and defined contribution plans.
Like other qualified plans, employer contributions cannot be "discriminatory" as defined by the Employee Retirement Income Security Act of 1974 (ERISA). In other words, the employer cannot give the lion's share of benefits to "highly compensated employees," typically owners and managers, while tossing a few crumbs to "nonhighly compensated employees," typically the rank-and-file workers. The percentage of any contribution allocated to a particular employee is also limited by the requirement of the Internal Revenue Code (IRC) that no more than $275,000 in annual compensation (in 2018, indexed) can be considered in formulating the allocation. Thus, if a plan calls for each participant to receive a contribution equal to 10% of annual compensation, the $300,000-per-year CEO could receive only $27,500 (10% of $275,000).
The amount of contributions allocated to a particular employee is further restricted by the IRC’s limit on “annual additions.” The limitation on annual additions to a participant’s account is the lesser of $55,000 (2018, indexed) or 100% of the participant’s compensation. The annual addition for any year is the sum of
You can see that an annual addition is when "new" money is added to the account. Earnings are not “new” money, so they are not considered to be an annual addition.
Table 1 summarizes some of the important characteristics of defined contribution plans that you should remember.
As you will see in this module, defined contribution plans come in many forms, each having different advantages and disadvantages for employers and employees. Furthermore, each operates under a unique sets of rules.
Kristen MacKenzie, MBA, CFP®, CRPC® is an associate professor at the College for Financial Planning. Kristen has over 20 years of experience in the financial services industry, both as an active financial planner and as a provider of financial education. She graduated from the University of Connecticut with a degree in economics and later received her MBA at the University of Colorado.
Michael Angell, CFP®, EA is an associate professor at the College for Financial Planning. He obtained his bachelor's degree in mathematics at Creighton University. His 20+ years of work experience includes banking, insurance, investments, retirement, and estate planning. In addition to his responsibilities at the College, Michael also serves as a private client services advisor with an independent investment firm and is also a federally licensed tax practitioner with a nationally recognized company. You can contact him at Michael.Angell@cffp.edu.