A defined contribution plan provides an individual account for each participant in the plan. It provides benefits to a participant largely based on the amount contributed to that participant's account. Benefits are also affected by any income, expenses, gains, losses, and forfeitures of other accounts that may be allocated to an account. A defined contribution plan can be either a profit-sharing plan or a money purchase pension plan.

A defined benefit plan is any plan that is not a defined contribution plan. Contributions to a defined benefit plan are based on what is needed to provide definitely determinable benefits to plan participants. Actuarial assumptions and computations are required to figure these contributions. Generally, you will need continuing professional help to have a defined benefit plan.

Forfeitures under a defined benefit plan cannot be used to increase the benefits any employee would otherwise receive under the plan. Forfeitures must be used instead to reduce employer contributions.

You must adopt a written plan. The plan can be an IRS-approved master or prototype plan offered by a sponsoring organization. Or it can be an individually designed plan.

In setting up a qualified plan, you arrange how the plan's funds will be used to build its assets.

You set up a trust by a legal instrument (written document). You may need professional help to do this.

You can set up a custodial account with a bank, savings and loan association, credit union, or other person who can act as the plan trustee.

You do not need a trust or custodial account, although you can have one, to invest the plan's funds in annuity contracts or face-amount certificates. If anyone other than a trustee holds them, however, the contracts or certificates must state they are not transferable.

You generally apply your plan contributions to the year in which you make them. But you can apply them to the previous year if all the following requirements are met.

There are certain limits on the contributions and other annual additions you can make each year for plan participants. There are also limits on the amount you can deduct. See Deduction Limits, later.

Participants may be permitted to make nondeductible contributions to a plan in addition to your contributions. Even though these employee contributions are not deductible, the earnings on them are tax free until distributed in later years. Also, these contributions must satisfy the nondiscrimination test of section 401(m). See Regulations sections 1.401(k)-2 and 1.401(m)-2 for further guidance relating to the nondiscrimination rules under sections 401(k) and 401(m).

The deduction limit for your contributions to a qualified plan depends on the kind of plan you have.

Defined benefit plans.   The deduction for contributions to a defined benefit plan is based on actuarial assumptions and computations. Consequently, an actuary must figure your deduction limit.

  

In figuring the deduction for contributions, you cannot take into account any contributions or benefits that are more than the limits discussed earlier under Limits on Contributions and Benefits. However, your deduction for contributions to a defined benefit plan can be as much as the plan's unfunded current liability.

If you make contributions for yourself, you need to make a special computation to figure your maximum deduction for these contributions. Compensation is your net earnings from self-employment, defined in chapter 1. This definition takes into account both the following items.

The deduction for your own contributions and your net earnings depend on each other. For this reason, you determine the deduction for your own contributions indirectly by reducing the contribution rate called for in your plan. To do this, use either the Rate Table for Self-Employed or the Rate Worksheet for Self-Employed in chapter 5. Then figure your maximum deduction by using the Deduction Worksheet for Self-Employed in chapter 5.

Deduct the contributions you make for your common-law employees on your tax return. For example, sole proprietors deduct them on Schedule C (Form 1040), Profit or Loss From Business, or Schedule F (Form 1040), Profit or Loss From Farming; partnerships deduct them on Form 1065, U.S. Return of Partnership Income; and corporations deduct them on Form 1120, U.S. Corporation Income Tax Return, or Form 1120S, U.S. Income Tax Return for an S Corporation.

Sole proprietors and partners deduct contributions for themselves on line 28 of Form 1040, U.S. Individual Income Tax Return. (If you are a partner, contributions for yourself are shown on the Schedule K-1 (Form 1065), Partner's Share of Income, Deduction, Credits, etc., you get from the partnership.)

If you contribute more to the plans than you can deduct for the year, you can carry over and deduct the difference in later years, combined with your contributions for those years. Your combined deduction in a later year is limited to 25% of the participating employees' compensation for that year. For purposes of this limit, a SEP is treated as a profit-sharing (defined contribution) plan. However, this percentage limit must be reduced to figure your maximum deduction for contributions you make for yourself. See Deduction Limit for Self-Employed Individuals, earlier. The amount you carry over and deduct may be subject to the excise tax discussed next.

Table 4-1 illustrates the carryover of excess contributions to a profit-sharing plan.

If you contribute more than your deduction limit to a retirement plan, you have made nondeductible contributions and you may be liable for an excise tax. In general, a 10% excise tax applies to nondeductible contributions made to qualified pension and profit-sharing plans and to SEPs.

There is a limit on the amount an employee can defer each year under these plans. This limit applies without regard to community property laws. Your plan must provide that your employees cannot defer more than the limit that applies for a particular year. For 2007 and 2008, the basic limit on elective deferrals is $15,500 per year. If, in conjunction with other plans, the deferral limit is exceeded, the difference is included in the employee's gross income.

If the total of an employee's deferrals is more than the limit for 2007, the employee can have the difference (called an excess deferral) paid out of any of the plans that permit these distributions. He or she must notify the plan by April 15, 2008 (or an earlier date specified in the plan), of the amount to be paid from each plan. The plan must then pay the employee that amount by April 15, 2008.

Under a qualified Roth contribution program, the amount of elective deferrals that an employee may designate as a Roth contribution is limited to the maximum amount of elective deferrals excludable from gross income for the year ($15,500 for 2007, $20,500 if 50 or over) less the total amount of the employee's elective deferrals not designated as Roth contributions.

Designated Roth deferrals are treated the same as pre-tax elective deferrals for most purposes, including:

A qualified distribution is a distribution that is made after the employee's nonexclusion period and:

An employee's nonexclusion period for a plan is the 5-tax-year period beginning with the earlier of the following tax years.

Since 2006 was the first year an employee could make designated Roth contributions, the earliest a qualified distribution can be made is January 1, 2011.

You must report a contribution to a Roth account on Form W-2, Wage and Tax Statement, and a distribution from a Roth account on Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. See the Form W-2 and 1099-R instructions for detailed information.

A qualified plan must provide that each participant will either:

These distribution rules apply individually to each qualified plan. You cannot satisfy the requirement for one plan by taking a distribution from another. The plan must provide that these rules override any inconsistent distribution options previously offered.

Generally, distributions cannot be made until one of the following occurs.

Distributions from a qualified plan minus a prorated part of any cost basis are subject to income tax in the year they are distributed. Since most recipients have no cost basis, a distribution is generally fully taxable. An exception is a distribution that is properly rolled over as discussed under Rollover, below.

The tax treatment of distributions depends on whether they are made periodically over several years or life (periodic distributions) or are nonperiodic distributions. See Taxation of Periodic Payments and Taxation of Nonperiodic Payments in Pub. 575 for a detailed description of how distributions are taxed, including the 10-year tax option or capital gain treatment of a lump-sum distribution.