Continuing the conversation in regard to benefits of employer sponsored plans, we will discuss defined contribution plans in this post. A defined contribution (DC) plan is a retirement plan in which employees allocate part of their paychecks to an account funding their retirements. The money you save for retirement in a defined contribution plan is invested in the stock market, and you may also get valuable tax breaks when you make contributions.
Defined contribution plans set up by the employer that do not promise a specific benefit at retirement. Instead, employees or their employer (or both) contribute to the employees’ individual accounts under the plan, usually at a set rate (such as 5-6 percent of salary annually). At retirement, an employee receives the accumulated contributions plus earnings (or minus losses) on the invested contributions.
- Popular Defined Contribution Plans
The most popular defined contribution plans include the traditional 401(k), profit-sharing plans, and employee stock ownership plans (ESOPs).
A 401(k) plan is a company-sponsored retirement account to which employees can contribute income, while employers may match contributions. There are two basic types of 401(k)s—traditional and Roth—which differ primarily in how they're taxed. With a traditional 401(k), employee contributions are pre-tax, meaning they reduce taxable income, but withdrawals are taxed. Employee contributions to Roth 401(k)s are made with after-tax income: There's no tax deduction in the contribution year, but withdrawals are tax free. Employer contributions can be made to both traditional and Roth 401(k) plans.
The IRS doesn't require employers match the employee's 401(k) contributions, but many employers do, and it can be a crucial selling point inside the company. A certain percentage of a firm's employees must participate for a plan to be considered legitimate by the IRS.
Generally, these plans must be offered to all employees at least 21 years old who worked at least 1,000 hours in a previous year.
In 2022, plan participants can contribute up to $20,500 per year if they’re under 50 ($22,500 in 2023). Those over 50 can contribute an additional $6,500 ($7,500 in 2023). Employers may contribute up to 25% of an employee’s compensation, but total employee and employer contributions cannot exceed $61,000 ($66,000 in 2023), or $67,500 ($73,500 in 2023) if they are 50 or older.
A profit-sharing plan gives employees a share in their company’s profits based on its quarterly or annual earnings. It is up to the company to decide how much of its profits it wishes to share.
Contributions to a profit-sharing plan are made by the company only; employees cannot make them, too.
A profit-sharing plan is available for a business of any size, and a company can establish one even if it already has other retirement plans. There is a lot of flexibility in how employers can implement a profit-sharing plan. As with a 401(k) plan, an employer has full discretion over how and when it makes contributions. However, all companies must prove that a profit-sharing plan does not discriminate in favor of their highly compensated employees. To implement a profit-sharing plan, all businesses must fill out an Internal Revenue Service Form 5500 and disclose all participants of the plan.
Employers can contribute up to the lesser of 25% of compensation or $61,000 ($66,000 in 2023).
Employee Stock Ownership Plans (ESOPs)
An employee stock ownership plan (ESOP) is an employee benefit plan that gives workers ownership interest in the company in the form of shares of stock. ESOPs encourage employees to invest deeply in their company’s success as that success translates into their own financial rewards. ESOPs also help staff to feel more appreciated and better compensated for the work they do.
ESOPs are set up as trust funds and can be funded by companies putting newly issued shares into them, putting cash in to buy existing company shares, or borrowing money through the entity to buy company shares. Because of the way they operate, companies with an ESOP are required to appoint a trustee to act as the plan fiduciary to avoid discrimination.
ESOPs present employees with a way to make more money, increase their compensation, and be rewarded for their hard work and commitment to the company. However, they are not always easy to administer and be frustrating if the participant doesn’t fully understand how they work. You made need to provide coaching and guidance for employees on how best to understand and take advantage of their participation on these plans.
In the last of this three part series of employer sponsored plans, we’ll be touching on defined benefit plans, also known as pension plans. The next article will dive deeper!
This information was developed as a general guide to educate plan sponsors, but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. In no way does advisor assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations.