Defined contribution

A retirement plan in which the employee and/or the employer contribute to the employee's individual account under the plan. the amount in the account at distribution includes the contributions and investment gains or losses, minus any investment and administrative fees. Generally, the contributions and earnings are not taxed until the distribution. the value of the account will change based on contributions and the value and performance of the investments. Examples of defined contribution plans include 401(k) plans, 403(b) plans, employee stock ownership plans and profit-sharing plans.

Defined Contribution explained

These plan types are primarily funded by the employee. The most common type of defined contribution plan being a 401(k). Participants can elect to defer a portion of their gross salary via pre-tax payroll deduction to the plan. the company may then make a profit sharing or match contribution if it elects, up to limits set by the IRS. 

As the employer has no obligation toward the account’s performance after the funds are deposited, these plans require little work, are low risk to the employer, and cost less to administer. 

The employee is responsible for making contributions and choosing investments offered by the plan. contributions are typically invested in select mutual funds, which contain a basket of stocks and/or other securities, and money market funds. however, the investment menu can also include annuities and individual stocks. 

The investments in a defined contribution plan grow tax-deferred until funds are withdrawn in retirement. There is a limit to how much employees can contribute each year. For 2022, for example, the most an employee can contribute to a 401(k) is $20,500, or $27,000 if they are 50 or older and make the catch-up contribution of $6,500. For 2023, the limit rises to $22,500, or $30,000 with the $7,500 catch-up contribution. 



An employee who signs up for a 401(k) agrees to have a percentage of each paycheck paid directly into an investment account. The employer may match part or all of that contribution. The employee gets to choose among a number of investment options, usually mutual funds. 

The 401(k) plan was designed by the United States Congress to encourage Americans to save for retirement. Among the benefits they offer is tax savings. 

With a traditional 401(k), employee contributions are deducted from gross income. This means the money comes from your paycheck before income taxes have been deducted. As a result, your taxable income is reduced by the total amount of contributions for the year and can be reported as a tax deduction for that tax year. No taxes are due on either the money contributed or the investment earnings until you withdraw the money, usually in retirement. 

Employers who match the employee contributions use various formulas to calculate the match. For instance, an employee might match 50 cents for every dollar that the employee contributes, up to a certain percentage of salary. 



The term 403(b) plan refers to a retirement account designed for certain employees of public schools and other tax-exempt organizations. Participants may include teachers, school administrators, professors, government employees, nurses, doctors, or librarians. 

The 403(b) plan, which is closely related to a 401(k) plan, allows participants to save money for retirement through payroll deductions while enjoying certain tax benefits. There’s also an option for the employer to match part of the employee’s contribution. 


Profit Sharing

A profit-sharing plan is a retirement plan that gives employees a share in the profits of a company. Under this type of plan, also known as a deferred profit-sharing plan (DPSP), an employee receives a percentage of a company’s profits based on its quarterly or annual earnings. A profit sharing plan is a great way for a business to give its employees a sense of ownership in the company, but there are typically restrictions as to when and how a person can withdraw these funds without penalties. 

Because employers set up profit-sharing plans, businesses decide how much they want to allocate to each employee. A company that offers a profit-sharing plan adjusts it as needed, sometimes making zero contributions in some years. In the years when it makes contributions, however, the company must come up with a set formula for profit allocation. 

For example: Lets assume a business with only two employees uses a comp-to-comp method for profit sharing. In this case, employee A earns $50,000 a year, and employee B earns $100,000 a year. if the business owner shares 10% of the annual profits and the business earns $100,000 in a fiscal year, the company would allocate profit share as follows:

Employee A = ($100,000 X 0.10) X ($50,000 / $150,000), or $3,333.33

Employee B = ($100,000 X 0.10) X ($100,000 / $150,000), or $6,666.67

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