Employees can benefit from a 401(k) plan even if the employer makes no contribution. Employees can voluntarily elect to make pre-tax contributions through payroll deductions up to an annual maximum limit ($20,500 in 2022). The plan may also permit employees age 50 and older to make additional “catch-up” contributions, up to an annual maximum limit ($6,500 in 2022). Employee contributions are 100% vested at all times.

The plan may also permit employees to make after-tax Roth contributions through payroll deductions instead of pre-tax contributions. Roth contributions allow an employee to receive a tax-free distribution of the contributions and of the earnings on the employee’s Roth contributions if the distribution meets certain requirements.

The employer will often match some portion of the amount deferred by the employee in order to encourage greater employee participation (e.g., 50% match on the first 6% deferred by the employee). Since a 401(k) plan is a type of profit-sharing plan, profit sharing contributions may be made in addition to, or instead of, matching contributions. Many employers offer employees the opportunity to take hardship withdrawals or to borrow from the plan.

Employee and employer matching contributions are subject to special nondiscrimination tests which limit how much the group of employees referred to as “Highly Compensated Employees” can defer based on the amounts deferred by the “Non-Highly Compensated Employees.” In general, employees who fall into the following two categories are considered to be Highly Compensated Employees:

• An employee who owns more than 5% of the business at any time during the current plan year or immediately preceding plan year (ownership attribution rules apply which treat an individual as owning stock owned by his or her spouse, children, grandchildren or parents); or
• An employee who received compensation in excess of the indexed limit in the preceding plan year (indexed limit is $135,000 in 2022). The employer may elect that this group be limited to the top 20% of employees based on compensation.

By doing so, certain employees may receive much higher allocations than would be permitted by standard nondiscrimination testing. New comparability plans are generally utilized by small businesses that want to maximize contributions for owners and higher paid employees, while minimizing contributions for all other eligible employees.

Employees are divided into groups based on valid business classifications, e.g., owners and non-owners. Each group may receive a different contribution percentage. For example, a higher contribution percentage may be given for the owner group than for the non-owner group, as long as the plan satisfies the nondiscrimination requirements.

The Safe Harbor requirements include certain minimum employer contributions and 100% vesting of employer contributions that are used to satisfy the Safe Harbor requirements. The benefit of eliminating the testing is that Highly Compensated Employees can defer up to the annual limit ($20,500 in 2022) without concern for how much the Non-Highly Compensated Employees defer.

A traditional defined benefit plan promises a fixed monthly benefit at retirement that is usually based upon a formula that takes into account the employee’s compensation and years of service. A cash balance plan looks like a defined contribution plan because the employee’s benefit is expressed as a hypothetical account balance instead of a monthly benefit.

Each employee’s “account” receives an annual contribution credit, which is usually a percentage of compensation, and an interest credit based on a guaranteed fixed rate or some recognized index like the 30 year U.S. Treasury bond rate which could vary. This interest credit rate must be specified in the plan document. At retirement, the employee’s benefit is equal to the hypothetical account balance which represents the sum of all contributions and interest credits. Although the plan is required to offer the employee the option of using the account balance to purchase an annuity benefit, most employees will take the cash balance and roll it over into an individual retirement account (unlike in many traditional defined benefit plans which do not offer lump sum payments at retirement).

As in a traditional defined benefit plan, the employer bears the investment risks and rewards in a cash balance plan. An actuary determines the contribution to be made to the plan, which is the sum of the contribution credits for all employees plus the amortization of the difference between the guaranteed interest credits and the actual investment earnings (or losses).

Employees appreciate this design because they can see their “accounts” grow, but they are still protected against fluctuations in the market. In addition, a cash balance plan is more portable than a traditional defined benefit plan since most plans permit employees to take their cash balance and roll it into an individual retirement account when they terminate employment or retire.

Defined benefit plans are usually funded entirely by the employer. The employer is responsible for contributing enough funds to the plan to pay the promised benefits, regardless of profits and earnings.

Employers that want to shelter more than the annual defined contribution limit ($61,000 in 2022) may want to consider a defined benefit plan since contributions can be substantially higher, resulting in a faster accumulation of retirement funds.

The plan has a specific formula for determining a fixed monthly retirement benefit. Benefits are usually based on the employee’s compensation and years of service which rewards long term employees. Benefits may be integrated with Social Security, which reduces the plan’s benefit payments based upon the employee’s Social Security benefits. The maximum benefit allowable is 100% of compensation (based on the highest consecutive three-year average) to an indexed maximum annual benefit ($245,000 in 2022). A defined benefit plan may permit employees to elect to receive the benefit in a form other than monthly benefits, such as a lump sum payment.

An actuary determines yearly employer contributions based on each employee’s projected retirement benefit and assumptions about investment performance, years until retirement, employee turnover and life expectancy at retirement. Employer contributions to fund the promised benefits are mandatory. Investment gains and losses cause employer contributions to decrease or increase. Non-vested accrued benefits forfeited by terminating employees are used to reduce employer contributions.