Defined Contribution Plans

Defined contribution plans focus on the contributions made to the plan by company employees – in contrast to defined benefit plans, which are designed to provide a specific benefit payout to an employee upon retirement. For the most part, defined contribution plans are tied to company profits and the company generally is not obligated to provide a certain, specified retirement benefit to any employee. The rationale is that the better the company does financially, the more it will be able to contribute to the plan (within legal limits) and thereby provide more for retirement benefits. Those benefits may be determined at retirement, at which time the amount in the plan participant's (the employee's) account is tallied and a distribution made.

Defined contribution plans may be in the form of either pension- or profit-sharing plans. Profit-sharing plans are established and maintained by companies primarily to provide for the participation in company profits by the employees or their beneficiaries. A qualified plan must provide a definite, predetermined formula for allocating among plan participants all contributions made to the plan. However, the amount of annual contributions, if any, is usually left to the discretion of the employer. Contributions are held in trust. When the employee retires or leaves under certain other circumstances, the contributions that have been allocated to that employee, including all earnings on those contributions, are distributed to the employee.Pension plans are established and maintained by employers interested in providing systematically for the payment of definitely determinable benefits to retired employees over a period of years -- typically for the remainder of the retiree's life. Retirement benefits are generally measured by and based on such factors as years of service and compensation received. The determination of the amount of plan contributions or benefits is not based upon the employer's profits, nor is it left in any way to the discretion of the employer.

When a profit-sharing or pension plan has been modified to provide a "cash or deferred arrangement" (or CODA), the resulting vehicle is popularly called a 401(k) plan after the section of the Internal Revenue Code that authorizes it.

The term "CODA" refers to two different methods by which the employee can defer a portion of his or her pay into the 401(k) plan. In the most common case, the employee is offered a cash bonus, all or part of which may be placed in or deferred into the plan on a before-tax basis. Alternately, the arrangement can take the form of a salary reduction agreement under which the employee elects to reduce his or her salary and place or defer the reduction amount into the plan, again on a before-tax basis. With either method, plan participants can avoid immediate taxation of the diverted bonus or salary deferral amount. Consequently, no income taxes are paid on the participating funds or their earnings until they're withdrawn. Thus, the 401(k) plan allows (within certain limits) a plan participant to augment the funds being contributed into his or her plan account on a tax-advantaged basis and therefore provide for greater retirement income.

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