The defined-contribution plan is an income tax incentive designed by the Internal Revenue Service to provide tax benefits to both employers and employees and to encourage the practice of saving for retirement. Although the term defined-contribution plan may not be widely recognized, this type of plan is actually the most common vehicle used for retirement savings and comes in many recognizable forms. Some of these include the common 401(k) plan, the 403(b) plan, employee stock ownership plans, profit sharing plans and money purchase pension plans. In 2015, defined-contribution plans in the United States held more than $6.7 trillion in retirement assets and were available to over 80% of full time employees of large companies as well as self-employed individuals and small business owners.
Although both defined-contribution plans and defined-benefit plans provide tax saving advantages for employers and employees as well as a retirement saving option for employees, they differ in how current contributions are calculated and how future benefits are determined. Defined-contribution plans generally determine the amount of the current allowable contribution without regard to future benefits, with the contribution based on overall IRS limits as well as specific limits included in the chosen plan. Conversely, defined-benefit plans establish the amount of the future retirement benefit a plan participant will need and then determine the current contributions needed to fund this future benefit. The future benefit is based on current actuarial calculations that take into account a variety of factors including the participant’s age, income and other factors.
Each year the IRS sets overall contribution limits for defined-contribution plans. In 2016, they allowed a maximum annual employee contribution of $18,000 for employees under age 50 and $24,000 for employees over age 50, with a total annual employer/employee contribution limit of $53,000 for all participants. Although all defined-contribution plans allow for employee tax deferrals that are generally determined by the employees and are subject to maximum IRS limits, the plans may take a variety of forms and provide for several types of contributions. In addition to employee deferrals, many plans allow for employer matching of employee contributions with more than 75% of employer 401(k) plans providing for employer contributions. Employer matching may range from 3% of an employee’s gross wages up to 100% dollar for dollar matching of employee contributions.
In addition to elective employee deferrals and employer matching, defined-contribution plans may provide for employer profit sharing contributions. The types of contributions are generally determined by the employer and are often based on annual company financial results. Contributions are either tax-deferred with taxable withdrawals or, in the case of a Roth, taxable with tax free withdrawals. In either case, the defined-contribution plan provides both the employer and the employee with a distinct tax advantage and generally allows assets set aside for retirement to grow larger over time. Defined-contribution plans may be used alone or in combination with other tax planning strategies to minimize income tax burdens for ordinary taxpayers as well as those with high-incomes. Strategies to maximize the tax saving benefits may include maximum contributions by business owners and employees as well as contributions by family members who may be involved with the operation of the business. In every case, total employee and employer contributions are limited to annual contribution limits set by the IRS.
The experienced professionals at CGT Solutions have a thorough understanding of the IRS guidelines regulating defined-contribution plans and can help you maximize the tax advantages they provide. If you are interested in investigating the use of a defined-contribution plan to save tax dollars and promote retirement savings, contact us today to receive a free, no obligation consultation.
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