A defined contribution plan is a retirement savings structure funded by contributions from both employees and employers. The exact retirement income will, however, depend on the performance of an employee’s investment choices.
As an employer, you have many options when it comes to helping your employees plan for their eventual retirement. It’s important to appraise them all equally, and establish which works best for your company and your staff. By far, the most popular form of employee savings system in the U.S. today is the defined contribution (DC) plan. Structured differently from a defined benefit (DB) plan, employees own DC plan assets themselves—and therefore bear sole responsibility for the funds’ performance.
While the exact structure varies from plan to plan, in general defined contribution plans generate savings by regularly deducting contributions from employee paychecks. Investments grow tax-deferred until withdrawn, and matching employer contributions can help boost a worker’s savings. Considering the two-pronged revenue stream of a defined contribution plan, which offers more than just maxing out a plan with a single contribution source, like a DB plan.
The U.S. Social Security Administration has found that companies have overwhelmingly trended toward DC plans for employee retirement funds in recent years. Considering their popularity, it is important to assess exactly what a DC plan can do for your business.
The Defined Contribution Plan: An Overview
In short, a defined contribution plan is a retirement savings structure funded by contributions from both employees and employers. The exact retirement income will, however, depend on the performance of an employee’s investment choices.
DC plans come with perks for employees and employers alike. Employees benefit from a reduced taxable income annually, due to pre-tax contributions. (Roth plans, which use post-tax contributions, are the exception here). Meanwhile, employers also benefit from potential tax write-offs.
Defined contribution plans also make employee participation optional. The company organizes the plan and decides which options an employee may choose from—options that might determine plan types, investment privileges available, and how the company will match contributions (if at all).
Different Defined Contribution Plan Types
The term “defined contribution plan” describes a general structure, but there are a number of different specific plans. These plans are categorized according to the type of company they are sponsored by. Each plan comes with its own tax implications, investment types, and withdrawal regulations.
You’re likely familiar with the 401(k), as it’s the most commonly offered defined contribution plan in the United States. 401(k)s are primarily funded with pre-tax contributions from an employee’s paycheck, bolstered by employer matched supplements. Employees select a percentage of their salary to deposit, which deducts automatically from their paycheck.
Since these contributions do not count toward annual taxable income, they can reduce an employee’s year-end tax liability, as well as tax withholding for the payment period.
Withdrawals from traditional 401(k) defined contribution plans are taxed at the current tax rate at the time of withdrawal. An alternative option known as a Roth 401(k) instead uses after-tax funds, which can appeal to employees who would prefer being taxed up front on the contributions. In this case, employer-matched funds are held in a complementary traditional 401(k), since employer contributions are generally pre-tax contributions.
Polaris Pro Tip: If you are in a low tax bracket, contributing to a Roth may make the most sense since you are locking in a lower tax bracket and shielding yourself from potential higher tax brackets when you eventually withdraw the funds.
401(k) funds are held until an employee reaches 59 years and six months of age, at which point the employee may access them regularly. Employees who need access sooner can tap into the funds ahead of time; however, early withdrawals may suffer a 10% penalty fee unless certain exceptions are met. On the other side, retired employees are subject to required minimum distributions (RMDs) after the age of 72, to help ensure account depletion over time. (If an employee is still working at age 72, they need only make withdrawals from previous employer plan. They need not do so at their current place of employment unless certain ownership rules of the organization are triggered.)
Similar to 401(k) defined contribution plans, 457 plans are specific to employees at non-profit organizations, as well as public workers in local and state governments.
Plan participants can contribute up to 100% of their salary in pre-tax deductions; however, the amount may not exceed the annual dollar limit established in the plan. These pre-tax deposits compound with interest, and remain untaxed until the time of withdrawal.
The 401(a) is another option generally utilized in the government and non-profit sectors. However, 401(a)s allow employers more control over fund investment than a 457 plan. They are generally low-risk plans, comprised of value-based stocks and government bonds.
This plan also permits contributions from both the employer and employee. The contributing employer determines the vesting schedule as well as eligibility. Employees have a number of withdrawal options with a 401(a), including lump-sum payments, annuity, or rollovers to other qualified pension plans.
Closely related to the 401(k), this defined contribution plan targets public school employees such as professors, teachers, nurses, librarians, administrators, as well as certain tax-exempt institutions. Employees contribute funds via automated payroll deductions (although there is a ceiling to how much employees can contribute annually).
The plan does make room for extra catch-up contributions, and provides for faster vesting of funds than some of the other options. However, the downside to a 403(b) is that one generally has a limited pool of investment choices—and in certain cases, these plans offer less protection from creditors.
Thrift Savings Plan (TSP)
Similar to a 401(k), this plan specifically caters to federal employees, uniformed services staff, and the Ready Reserve. Federal employees can receive a tax break for savings, or invest in a Roth plan to ensure tax free distributions in retirement. There are six investing options in which participants can place their funds.
SIMPLE 401k Plan
The Savings Incentive Match Plan for Employees (SIMPLE) offers another option small business owners should consider for their employees. Businesses with 100 or fewer employees are eligible to offer this adjusted 401(k). As long as employees are 21 years or older and have completed one year with the company, they can borrow against their plan balance and are immediately fully vested.
Employers opting to offer their staff this plan must meet eligibility criteria, and may not provide other options to employees. Contribution limits are also somewhat lower than other plans, with the IRS setting the annual limits.
A Note on Employer and Employee Contributions
Defined contribution plans always incorporate employee pay-in (thus the “contribution” part of the term). However, employers must make the decision whether to reciprocate. Employers can offer matching contributions, no contributions, or non-elective contributions for an employee’s retirement plan.
Matching contributions are only made to employee accounts if the employee contributes to the fund themselves. The employer generally uses a formula to calculate a predetermined percentage to coincide with the participant’s investment contributions. Some employers, however, prefer to use flat dollar amounts instead.
If you choose to offer matching contributions of any amount, your plan documentation should specify either the formula by which the employer will determine their contribution or a pre-determined dollar amount. Should this amount or percentage decrease at any time, you must amend your plan immediately, as these changes will only pertain to payments made after the amendment is adopted. You cannot apply a decrease retroactively.
Meanwhile, non-elective contributions—while also based on a fixed amount or discretionary formula—are not conditional to the employee’s decision to invest in the plan.
Types of Employee Contributions
Across the various defined contribution plans, there are a number of ways employees can make their contributions. However, they generally fall into one of three categories: pre-tax, post-tax, or rollover.
Pre-tax contributions defer income taxes until contributions are released from the plan at a later stage, generally around retirement. The contribution amount is deducted from the employee’s taxable income salary, which can reduce a person’s marginal tax bracket and income taxes paid in the current year.
Meanwhile, post-tax contributions do the opposite. These funds are taken from an employee’s salary after income taxes have been deducted. Employees opting for this model (generally the calculus of a Roth 401(k) or IRA) won’t pay taxes upon withdrawal of contributions. It is important to recognize the difference between post-tax contributions and after-tax non-deductible contributions. Post-tax grows tax free, even on the earnings. Non-deductible after tax does not grow tax free, meaning the earnings will be taxed but the original basis comes out tax free.
Finally, employees can also consolidate their retirement savings in one place with rollover payments. The plan would therefore accept contributions from other qualified retirement plans or IRAs. This consolidates and increases the plan’s overall assets, presenting the potential to qualify for lower expense ratios and administrative fees.
Investing Participants’ Accounts
Once you’ve established a defined contribution plan system for your employees, it’s critical to invest the funds properly. One can allocate asset investment responsibility in a participant- or administrator-directed manner.
A participant-directed approach entrusts the employee with the responsibility of directing their own investments. The plan administrator will set guidelines addressing the frequency of investment changes, the range of options offered, and access to investment information. The employee can then make decisions accordingly that reflect their own risk margins, expected investment prospects, and external retirement assets.
Meanwhile, an administrator-directed approach requires a plan administrator to fully manage all asset investments in the plan. In this scenario, individual participants do not have permission to direct investments themselves. Plan administrators have complete fiduciary responsibility and hold potential liability for asset investments.
But it’s not strictly either-or. One can also establish a combination middle path, in which participants can direct the investment of their contribution portion, and an administrator retains investment authority for the remainder of the plan assets.
Loans and Withdrawals
Various plans have different criteria governing employees’ ability to take withdrawals or loans against their defined contribution accounts while still employed and/or under retirement age. Note that criteria may vary according to the company and specific plan in question.
Loans are sometimes permitted, for amounts within ERISA- and Internal Revenue Code-imposed limits. Outstanding loan balances generally cannot exceed 50% of the employee’s account balance, or a $50,000 maximum during 12 months. However, if 50% of a vested account balance is less than $10,000, the employee is usually permitted a loan up to $10,000. Reasonable interest rates on loans will apply.
After reaching 59 years and six months of age, an account participant may withdraw from their account at will. In a few select circumstances, early withdrawals may be permitted.
For example, participants who are younger than the defined age can make in-service withdrawals from after-tax contributions. This only applies to employer contributions if they have been credited to the employee’s plan for at least 24 months. There may be specific regulations around the frequency and number of withdrawals permitted, depending on the individual plan.
As with in-service withdrawals, employees under the defined age can also withdraw funds in times of severe financial hardship, if established requirements are met. New regulations allow a birth or adoption clause for early distributions, up to $5000. These are penalty-free early withdrawals to assist with birth or adoption expenses, and must occur within the 12 months following the child’s birth or adoption. Participants may re-contribute the funds later if they so choose.
Streamline Your Defined Contribution Plan Management
While there are a host of defined contribution plan options, selecting the right one for your company is crucial. In these instances, employing the services of a competent wealth and investment manager can help.
Polaris Wealth Advisory Group can simplify the process by designing and administrating defined contribution plans. From initial plan evaluation to compliance and ongoing employee education, Polaris Wealth can customize services to meet your unique business needs, even assuming fiduciary duties if required.
In an ever-changing regulatory environment, it helps to have someone on your side. Reach out to Polaris today and schedule a complimentary competitive employer-sponsored retirement plan analysis to get started.
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