Financial Learning Center
- Defined Benefit Plans: Fixed Income for Life?
- Defined Contribution Plans: Brief Descriptions
Rather than making contributions that fund a future benefit, annual contributions to your defined-contribution retirement account are made by you, your employer, or both. Your contributions accumulate, based on the performance of your plan's investments, and you receive the balance in your account when you leave the company (subject to the company's vesting schedule, if any). Generally, these plans fall into two major categories: money purchase plans and profit-sharing plans.
- Money purchase plans require the company, every year, to contribute a fixed percentage of your salary. The company has to make the contribution even if the company has not made a profit.
- Profit-sharing plans do not require mandatory contributions. While the company agrees to make recurring contributions to the plan, they are considered discretionary. Although the company's annual contribution to the plan is usually based on the company's profits, past or current profits are not required for the company to contribute to the plan. A company can also skip its contribution in a given year, depending on the particular plan.
The most popular type of profit-sharing plan is a 401(k) plan. Other types of defined-contribution plans include thrift plans, 403(b) plans, Section 457 plans, stock bonus plans, SIMPLE Plans, employee stock ownership plans (ESOPs), employee stock option plans, stock purchase plans and simplified employee pensions (SEPs).
Hybrid plans combine characteristics of both defined benefit plans and defined contribution plans. These plans provide employer benefits based in part on separate account balances for each participant.
- Target Benefit Plans—A target benefit plan acts like a defined contribution plan but adds features of a defined benefit plan because contributions are determined on the amount needed to fund a future benefit.
- Cash Balance Plans—A cash balance plan is a defined benefit plan in which the employee's benefit is determined on the basis of what a hypothetical account would be worth if the employer had made certain contributions and the contributions had grown at an assumed rate.
The type of plan a company has is determined by the company itself.
The most popular type of company savings plan, a 401(k) plan, permits employees to make contributions from their salary before the money has been taxed, i.e., you are saving with pre-tax dollars. (Some companies also offer the option of Roth 401(k) contributions, where the contribution is made with after-tax dollars, but growth occurs on a tax-free basis.) Your contribution is automatically deducted from your paycheck. You receive a statement detailing the amount of your contributions, your employer's contributions (if the employer has a formula for matching contributions), beginning balance, ending balance, and how your money is invested. With this type of plan, you are responsible for funding your retirement, so the contribution and investment decisions you make will affect your account balance. Distributions from a 401(k) plan are taxed as ordinary income, except for earnings on Roth 401(k) contributions, which are subject to special tax rules and may not be taxable if applicable holding period and other requirements are met.
SUGGESTION: Take advantage of your 401(k) plan. Consider contributing the maximum allowable.
Your plan will offer you several investment choices. Surveys conclude that most participants invest too conservatively. Many young people have their savings in fixed interest accounts and guaranteed investment contracts. Besides fixed-interest rate funds, you may have choices of one or more stock mutual funds, government bond funds, balanced funds, asset allocation funds and your own company's stock fund. You can choose how much of each contribution should be invested in each fund, and you can transfer your existing balances from fund to fund.
These are also known as savings plans for federal civil service employees and members of uniformed services. A Thrift Savings Plan provides the same tax deferred savings as a private sector 401(k) plan. Beginning in 2012, a Roth feature has been added to the Thrift Savings Plan.
403(b) plans are available to employees of public educational organizations and Internal Revenue Code section 501(c)(3) tax-exempt organizations.
403(b) plans allow you to make elective pre-tax contributions to the plan and to defer tax on income until retirement. Distributions from a 403(b) plan are taxed as ordinary income. (As with a Roth 401(k) plan, some employers offer a Roth 403(b) plan. Here, while your contribution is made with after-tax dollars, growth occurs on a tax-free basis.)
Section 457 Plans
Section 457 plans are available to employees of a state government or agency, or any non-church controlled tax-exempt organization (civic, religious, charitable, educational, business leagues, certain credit unions and mutual insurance funds).
Section 457 plans, like 403(b) and 401(k) plans, allow you to make elective pre-tax contributions to the plan and to defer tax on income until retirement. Distributions from a 457 plan are taxed as ordinary income.
(For more detailed information on this topic see the section Investing for Retirement)
Stock Bonus Plans
A stock bonus plan provides benefits similar to those in profit-sharing plans, except that the employer's contributions are made in shares of company stock. (In certain circumstances, the company can make benefit distributions in cash.) If you have such a plan, you have ownership in the company and an incentive to help ensure the company's profitability. By issuing its own stock, the company saves money. And as long as the company's share price increases, it's a win-win situation for the employer and the employee. On the other hand, if the stock's price declines when you're nearing retirement, it can jeopardize your retirement.
IMPORTANT NOTE: If your retirement fund consists primarily of your company stock, consider diversifying into other investments the nearer (five years or less) you are to retirement. Even if you're more than five years from retirement, you increase the risk factor and could possibly limit the long-term rate of return on your investments if your fund consists primarily of company stock.
Savings Incentive Match Plan for Employees (SIMPLE plans) may be adopted by employers with 100 or fewer employees who earn at least $5,000 during the preceding year. SIMPLE plans may be in the form of an IRA or part of a 401(k) plan. If you are part of a SIMPLE plan, you may not defer more than $13,000 in 2019 ($12,500 in 2018). Age 50 or older participants may have a catch-up contribution of an additional $3,000 (same in 2018).
Employee Stock Ownership Plans (ESOPs)
While the primary purpose for establishing an ESOP is really to allow employees to own a piece of their own companies, ESOPs have become a mechanism for companies to improve their financial position.
If your company has an ESOP, here are a few things you should know:
- The amount of stock contributed to your account is based on a predetermined formula, which may reflect a percentage of compensation, flat rate or years of service. The plan determines the actual formula.
- You may have voting rights based on the ESOP stock in your account.
- Generally, the amount of stock in your ESOP account cannot be sold or transferred. Typically, when you leave the company or retire, you can take the shares, or receive the shares' value in cash. The terms of the plan will determine whether your benefit will be distributed in cash, shares of stock, or both.
- Because your retirement funds should be diversified, there are typically certain escape provisions you should consider exercising. When you have completed at least ten years of participation in the ESOP and reach age 55, you can elect to diversify the ESOP stock you received after 1986. The law allows you to elect to diversify at least 25% of your ESOP assets all at once or over a five-year period. In the sixth year, you can elect to diversify at least 50% of the remaining balance.
IMPORTANT NOTE: Don't ignore these important diversification provisions. You can potentially your risk by balancing your assets.
Employee Stock Option Plans
There are several different types of stock option grants that employers may choose to give to employees:
- Incentive Stock Options
- Nonqualified Stock Options
- Stock Appreciation Rights
Incentive stock options or ISOs are options that qualify for favorable tax treatment as long as certain rules outlined in the tax code are followed. The favorable tax treatment includes no ordinary income tax at date of exercise. In addition, when the shares of stock are sold, the dollar difference between the sale price and the options price is taxed at long-term capital gains tax rates, which can be lower than the tax rates on ordinary income. Certain rules must be followed. If those rules are violated, the incentive stock options lose their status and are treated, for tax purposes, as nonqualified stock options.
Nonqualified stock options or NQSOs are options that do not qualify for the same favorable tax treatment (i.e., long-term capital gains). Nonqualified stock options are the most common type of option granted to employees.
A stock appreciation right or SAR is the right to receive, in cash or company stock, the difference between the price of the company's stock on the date of grant of the SAR and the price of the stock at the time of exercise of the SAR. There are three different types of stock appreciation rights: tandem, parallel and freestanding.
- Tandem SARs are rights that are granted with another type of stock option. The exercise of one SAR cancels one stock option, and vice versa.
- Under parallel SAR / stock option plans the employee receives a grant of both SARs and stock options. The exercise of one is completely separate from the exercise of the other. Companies will sometimes grant parallel SARs to provide employees with the cash to exercise their stock options. An employee could exercise the SARs and then use that money to exercise his or her stock options.
- Freestanding SARs are stock appreciation rights that are not attached to any other stock options. Exercising freestanding SARs in no way affects any other options an employee may have.
Why Companies Use Stock Options
Companies use stock options because they believe offering employees potential ownership in the company will encourage them to think of themselves as owners in the business and motivate them to help in the achievement of the long-term goals of the company. When the company achieves its long-term goals and corporate financial performance is consistently good, the price of the company stock tends to rise. Everybody benefits: Shareholders benefit because increases in the price of the company's stock translate into increased net worth for the shareholder. Employees with stock options benefit because the difference between the current stock price and the option price can increase, and therefore the value of their option can increase.
Stock Purchase Plans
Your company may allow you to purchase shares of its stock through payroll deduction. Fixed amounts are deducted from your paycheck, and you can purchase either full or fractional shares. You avoid paying any brokerage fees and the dividends can automatically purchase additional shares commission-free.
SUGGESTION: If your company is well positioned for long-term growth, you may consider purchasing stock for long-term financial objectives such as a child's college education.
IMPORTANT NOTE: Company pride can make too much of a good thing bad. Throwing all your savings into your company's stock could mean exposing your savings to excessive risk. Balance your company stock with other assets and asset classes and maintain a well-diversified portfolio. Although the long-term trend of your company's stock may generally be upward, it may move quicker or slower than other investments you could make.
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