There are several types of defined contribution plans. First, a profit sharing plan is a retirement plan to which an employer makes contributions on behalf of all (or some subset) of the eligible employees. The contribution amounts are discretionary. The employer decides each year the amount, if any, to be contributed to the plan.
For tax deduction purposes, the company contribution cannot exceed 25% of the total compensation of all benefiting employees. The maximum amount which can be allocated to any one participant is 100% of the participant’s compensation or $57,000 in 2020 (subject to cost-of-living adjustments for later years), whichever is less.
The company contributions can be subject to a vesting schedule that provides that an employee’s right to the contribution becomes nonforfeitable only after a period of time.
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A 401(k) plan is an employer-sponsored plan that allows eligible employees to make pre-tax elective deferrals or post-tax “Roth” contributions through payroll deductions. In addition to the 401(k) features, a typical 401(k) plan may provide discretionary employer profit sharing contributions to all (or some subset) of participants, matching contributions based on employees’ elective deferrals, or both. As in a traditional profit sharing plan, these employer contributions can be subject to a vesting schedule.
The maximum amount that an employee can contribute annually to a 401(k) plan for 2020 is $19,500. The limit is subject to cost of living adjustments in future years. 401(k) deferrals count towards the $57,000 annual addition limit mentioned above. Participants age 50 and older can make additional “catch up” contributions to a 401(k) plan. The maximum “catch up” contribution for 2020 is $6,500.
Rules relating to traditional 401(k) plans require that contributions made under the plan meet specific nondiscrimination requirements. In order to verify that deferred wages and employer matching contributions do not discriminate in favor of highly compensated employees, the employer must perform annual tests, known as the Average Deferral Percentage (ADP) and Average Contribution Percentage (ACP) tests. Alternatively, there are Safe Harbor designs that can be used to avoid such testing.
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A money purchase plan operates similarly to a profit sharing plan. The major difference is, unlike profit sharing plans where employers are permitted to make discretionary contributions each year, the employer has a set contribution rate which is stated in the plan document. These contributions are mandatory and must be made each year regardless of the employer’s profit. Failure to make the contribution can result in penalties.
With the passage of EGTRRA in 2001, the advantages of maintaining a money purchase plan have largely disappeared. Prior to that time, a money purchase plan provided for a higher maximum contribution percentage than a profit sharing plan because money purchase plans enjoyed a higher deduction limit as a percentage of pay than profit sharing plan. However, with the passage of EGTRRA in 2001, beginning in 2002, this difference in the tax deduction limit was eliminated. Therefore, most money purchase plans have been or will be converted to profit sharing plans to provide employers with more flexibility in determining their contributions from year to year.
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