Types of Qualified Retirement Plans
Qualified plans can be set up as either:
- A Defined Benefit Plan, or
- A Defined Contribution Plan
Defined Benefit Plan
A defined benefit plan promises a specific benefit amount at retirement. For example, $3,000 per month. To ensure retirees receive their promised benefit, the company must adequately fund the plan over the years. Actuaries are used to figure out the annual funding requirement.
Defined Contribution Plan
Under a defined contribution plan, no specific benefit amount is promised. The benefit you ultimately receive at retirement depends on:
- Contributions made to the plan, plus
- Earnings and gains on plan assets, minus
- Losses and expenses incurred by the plan
A defined contribution plan can be either:
- A Money Purchase Pension Plan, or
- A Profit-Sharing Plan
Money Purchase Pension Plan
Under a money purchase pension plan:
- Contributions are fixed.
- Contributions are based on compensation, regardless of business profits.
For example, if the plan calls for contributions of 10% of a participant's compensation, you must make those contributions without regard to whether you have a profit or loss.
Self-employed persons (sole proprietors and partners):
A self-employed person can only make contributions for himself to a qualified plan if he has net earnings from self-employment in the business for which the plan was set up.
For a sole proprietor, net earnings from self-employment is net profit on Schedule C (or Schedule F) minus one-half of the self-employment tax liability, figured on Schedule SE (this is the above-the-line deduction claimed on the front of Form 1040, Line 27).
Regarding partners, each partner must reduce his share of partnership earnings reported on Schedule K-1 by one-half of his self-employment tax liability.
Under a profit-sharing plan, contributions are geared toward profits. It is a plan for sharing business profits with employees. However, you do not have to actually make contributions out of profits to have a profit-sharing plan. And the plan does not need to provide a definite formula for figuring the profits to be shared.
However, if their is a formula, there must be systematic and substantial contributions and there must be a definite formula for:
- Allocating the contributions among the participants and
- Distributing the accumulated funds to the employees after they reach a certain age, after a fixed number of years, or upon certain other occurrences.
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- Return to the Retirement Plans Table of Contents to find related links