Defined contribution (DC) plans, also known as individual account plans, define the contribution a participant receives under the plan. The Employer contributions are allocated to individual accounts maintained for each participant within the plan. The total contributions plus total investment earnings of the participant’s account is the participant’s retirement benefit from the plan.
The participant bears the investment risk in a DC plan. There is no guaranteed amount paid to the participant. Investment results are not guaranteed, and do not affect the Employer’s cost of funding contributions to the plan.
The contributions made by Employers to a DC plan can be allocated to participants’ accounts under different types of allocation formulas, as described below:
- The simplest formula is salary ratio, in which each participant
receives the same contribution as a percent of compensation.
This type of formula satisfies IRS safe harbor rules, which
means that the contribution allocations automatically satisfy
IRS nondiscrimination requirements.
- Another IRS safe harbor allocation formula is permitted disparity
(or integrated). Such a formula provides an additional allocation
of up to 5.7% of excess compensation to each participant with
excess compensation. Excess compensation is typically defined
to be any compensation in excess of the Social Security Taxable
Wage Base.
- Cross-tested allocation formulas do not satisfy IRS safe harbor
rules. Instead, they must be general-tested each year, in accordance
with IRS nondiscrimination test requirements.
Under a cross-tested formula different rates of contribution can be allocated among different groups of eligible employees. Given the right demographics, cross-tested allocation formulas can provide key employees with substantially greater contribution leveraging than any of the IRS safe harbor allocation formulas.
A profit sharing plan is a type of DC plan, whereby contributions each year are subject to the discretion of the Employer. The Employer contribution each year can range anywhere from zero, up to the maximum tax deductible amount of 25% of eligible payroll.
A 401(k) plan is a type of profit sharing plan, whereby each eligible employee is permitted to make contributions on a pre-tax basis.