There are two different types of pension plans. The first is known as a fixed or defined benefit plan. Here, definitely determinable retirement benefits are computed using a predetermined benefit formula established when the plan is created. Each employee is promised a specific amount of retirement benefits. The employer’s contribution to provide the benefit is based on an actuarial determination of the cost of benefits planned. In other words, contributions are based on benefits and the limits on contributions are based on the benefit they will produce.
A money purchase pension plan, which is a type of defined contribution plan, bases the retirement benefit upon an employer’s commitment to make an annual contribution. Benefits are directly dependent upon the length of time an employee participates in the plan and the amount of money contributed on his behalf each year (plus interest and appreciation on such funds). In a money purchase pension plan, therefore, the employer is not obligated to provide a specific amount of retirement benefits.
A profit-sharing plan is an arrangement by which an employer shares a portion of corporate profits with employees. Contributions can be made even if there are no profits. It is a type of defined contribution plan. For all defined contribution plans, the limits on annual contributions to the plans are based on a percentage of salary, which directly limits the contributions. There is no limit to the benefits produced by the plan.
A 401(k) plan may stand on its own (e.g., permit only elective contributions) or it may permit other types of employer contributions and/or employee contributions. Under this type of arrangement, an employee can elect to have the employer make an elective contribution on his behalf in the form of a compensation reduction agreement under which the employee elects to reduce cash compensation and to have the employer contribute such amount to the plan on the employee’s behalf. In some cases the employer may agree to make a contribution based on the employee’s contributions (e.g. 50 cents from the employer for every dollar put in by the employee from his or her compensation)
When is the use of such a devise indicated?
- When you would like to be sure of a steady, adequate, and secure personal retirement income.
- When you would like to set aside money for retirement on a tax deductible basis.
- When you want to reward long-service employees and provide for their economic welfare after retirement.
- When you would like to put your business in a better competitive position for attracting, retaining, and eventually retiring personnel.
- When your corporation is about to run into an accumulated earnings tax problem. The corporation would like to “siphon off” some of its earnings and profits and reduce or eliminate the threat of a penalty tax on unreasonably accumulated earnings.
- When you have employees who would like to defer compensation on an elective, pre-tax basis to a qualified retirement plan.