F.47.2 Defined Contribution Plans

Defined Contribution Plans

Defined contribution (DC) plans specify the contribution amount rather than the retirement benefit. Unlike defined benefit plans where the employer promises a specific benefit, DC plan participants receive whatever their account balance grows to be based on contributions and investment performance. The employee bears all investment risk.

Key Characteristics of DC Plans

Types of Defined Contribution Plans

DC plans fall into two main categories: pension plans and profit sharing plans.

DC Pension Plans

Money Purchase Pension Plans:

• Mandatory annual funding of a fixed percentage (up to 25% of covered compensation)
• Rarely established after EGTRRA 2001 due to profit sharing plans achieving same limits

Target Benefit Pension Plans:

• Special type of money purchase plan
• Contribution determined by participant's age to achieve a target benefit
• Requires actuary at inception only (not annually)
• Favors older employees (unlike other DC plans)

Profit Sharing Plans

The more common type of DC plan, profit sharing plans include several variations:

Profit Sharing Plans

Core Characteristics

• Established and maintained by an employer
• Provides for employee participation in company profits
• Uses a definite predetermined formula for allocating contributions
• Must be nondiscriminatory

Contribution Rules

Discretionary but Substantial and Recurring:

• Employer contributions are discretionary (can vary year to year)
• However, contributions must be "substantial and recurring" to maintain qualified status
• No requirement for actual company profits to make contributions

Contribution Limits:

• Limited to 25% of total covered compensation for employer deduction
• Per-employee limit: Lesser of 100% of compensation or $72,000 (2026)

Allocation Methods

Key Point: Profit sharing plans can only use the excess method for Social Security integration (not the offset method).

401(k) Plans / Cash or Deferred Arrangements (CODA)

A 401(k) is a Cash or Deferred Arrangement (CODA) attached to a profit sharing or stock bonus plan.

Key Features

• Most prevalent type of qualified plan established today
• Predominantly funded by employee salary deferral contributions
• Permits employees to defer pre-tax (or Roth) compensation to a qualified plan
• Employers may match employee deferrals (not required)

2026 Contribution Limits

Eligibility and Vesting

• Cannot use 2-year eligibility rule (unlike other qualified plans)
• Must use standard age 21 and 1 year of service
• Employee deferrals are 100% vested immediately
• Employer contributions vest under standard schedules:
  • 2-6 year graded, or
  • 3-year cliff

ADP/ACP Testing

401(k) plans must pass discrimination testing:

• ADP Test (Actual Deferral Percentage): Limits HC elective deferrals based on NHC deferrals
• ACP Test (Actual Contribution Percentage): Tests employer matching and after-tax contributions

Safe Harbor 401(k) Plans avoid ADP/ACP testing by providing either:

• 3% non-elective contribution to all eligible employees, OR
• Matching: 100% on first 3% + 50% on next 2% of deferrals

CFP Exam Tip: Safe harbor employer contributions must be 100% vested immediately.

2026 Annual Additions Limit (IRC 415(c))

The maximum annual additions to a participant's DC account for 2026:

Lesser of:

• $72,000, or
• 100% of the participant's compensation

Annual additions include:

• Employer contributions
• Employee deferrals (pre-tax and Roth)
• Forfeitures allocated to the participant's account

NOT included:

• Catch-up contributions (age 50+)
• Rollover contributions

Stock Bonus Plans

Stock bonus plans are profit sharing plans where employer stock is the primary investment:

Key Features

• Contributions can be made in cash or employer stock
• Distributions typically made in employer stock
• Employer receives tax deduction for FMV of stock contributed (cashless tax deduction)
• Contributions are discretionary but must be substantial and recurring
• Can invest 100% in employer securities (unlike pension plans limited to 10%)

Net Unrealized Appreciation (NUA)

A significant tax benefit available for lump-sum distributions of employer securities:

How NUA Works:

1. Employee takes a lump-sum, in-kind distribution of employer stock
2. At distribution:
   • Ordinary income = Value at date employer contributed the stock (cost basis)
   • 10% early withdrawal penalty applies only to the cost basis (if applicable)
   • NUA is NOT taxed at distribution
3. When stock is sold:
   • NUA = Long-term capital gain (regardless of holding period)
   • Additional appreciation after distribution = capital gain (ST or LT based on holding period)

NUA Calculation:

Example: Stock with $30,000 cost basis distributed when worth $100,000, later sold for $120,000:

• Ordinary income at distribution: $30,000
• LTCG (NUA) at sale: $70,000
• Additional gain (ST or LT): $20,000

CFP Exam Note: NUA treatment is lost if stock is rolled to an IRA instead of taking the lump-sum distribution.

Employee Stock Ownership Plans (ESOP)

An ESOP is a special type of stock bonus plan with unique features:

Key Characteristics

• Established as a trust that holds employer stock
• Can be leveraged (ESOP borrows to buy employer stock)
• Employer can deduct principal and interest on ESOP loans
• Dividends paid on ESOP stock are tax-deductible to employer
• Cannot use Social Security integration for allocations

ESOP Voting Rights

ESOP Distributions

• Participant can demand distribution in employer securities
• Put option: Employee can require employer to repurchase stock at FMV
• Substantially equal periodic payments allowed (5-10 year period for large accounts)
• Lump-sum distribution qualifies for NUA treatment

ESOP Diversification

Qualified participants (age 55+ with 10 years participation) during their 6-year qualified election period may diversify:

• Years 1-5: Up to 25% of post-1986 employer stock
• Year 6: Up to 50% of post-1986 employer stock

DC Plans: Who They Favor

Defined contribution plans generally favor younger employees because:

• Younger employees have more years for compound growth
• Same dollar contribution grows much larger over 30+ years vs. 10 years
• No credit for prior service (unlike DB plans)
• Investment gains benefit the individual account holder

Exception: Target benefit pension plans favor older employees because contributions are calculated to achieve a specific benefit at retirement, requiring larger contributions for older participants.

Forfeitures in DC Plans

When employees leave before fully vesting, their non-vested employer contributions are forfeited:

Forfeiture Uses:

• Reduce employer contributions, OR
• Reallocate to remaining participants

Contrast with DB Plans: In defined benefit plans, forfeitures can ONLY reduce plan costs, not be allocated to other participants.

Comparison: DB vs. DC Plans