Key Takeaways
- DC plans define contributions, not benefits; employee bears all investment risk
- 2025 annual additions limit is $70,000 (or 100% of compensation if less) under IRC 415(c)
- DC plan types include profit sharing, 401(k), money purchase pension, stock bonus, and ESOP
- Profit sharing contributions are discretionary but must be substantial and recurring
- DC plans favor younger employees who have more time for compound growth
- Net Unrealized Appreciation (NUA) treatment available for lump-sum distributions of employer stock
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
| Characteristic | Defined Contribution Plan |
|---|---|
| What is Defined | Contribution amount/formula |
| Investment Risk | Employee |
| Account Type | Separate individual accounts |
| Mandatory Funding | Generally no (except money purchase) |
| Favors | Younger employees |
| PBGC Coverage | No |
| 2025 Annual Additions Limit | Lesser of $70,000 or 100% compensation |
Types of Defined Contribution Plans
DC plans fall into two main categories: pension plans and profit sharing plans.
DC Pension Plans
| Plan Type | Funding | Actuary | Who Favors |
|---|---|---|---|
| Money Purchase Pension | Mandatory (fixed %) | No | Younger employees |
| Target Benefit Pension | Mandatory (varies) | At inception only | Older employees |
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:
| Plan Type | Key Feature | Contributions |
|---|---|---|
| Profit Sharing | Discretionary employer contributions | Employer only |
| 401(k) / CODA | Employee salary deferrals | Employee + Employer |
| Stock Bonus | Distributions in employer stock | Employer stock |
| ESOP | Invested primarily in employer stock | Employer (often leveraged) |
| Thrift Plan | After-tax employee contributions | Employee + Employer match |
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 $70,000 (2025)
Allocation Methods
| Method | Description | Effect |
|---|---|---|
| Pro-rata | Equal percentage to all participants | Standard allocation |
| Social Security Integration (Excess) | Higher allocation above SS wage base | Favors higher-paid |
| Age-Based | Combines age and compensation | Favors older employees |
| New Comparability | Based on employee classification | Allows discrimination by class |
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)
2025 Contribution Limits
| Contribution Type | 2025 Limit |
|---|---|
| Employee Deferral | $23,500 |
| Age 50+ Catch-up | $7,500 |
| Ages 60-63 Super Catch-up | $11,250 |
| Total Annual Additions (415(c)) | $70,000 |
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.
2025 Annual Additions Limit (IRC 415(c))
The maximum annual additions to a participant's DC account for 2025:
Lesser of:
- $70,000, 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
| Component | Included in 415(c)? |
|---|---|
| Employer contributions | Yes |
| Employee deferrals | Yes |
| Forfeitures | Yes |
| Age 50+ catch-up | No |
| Rollovers | No |
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:
- Employee takes a lump-sum, in-kind distribution of employer stock
- 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
- 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:
| Component | Tax Treatment |
|---|---|
| FMV at Distribution | Not fully taxed at distribution |
| Less: Employer's Cost Basis | Ordinary income at distribution |
| = Net Unrealized Appreciation | LTCG when stock is sold |
| Post-distribution appreciation | Capital gain based on holding period |
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
| Company Type | Voting Rights |
|---|---|
| Publicly Traded | Full voting rights on all matters |
| Privately Held | Vote only on major corporate decisions (mergers, acquisitions, liquidation, etc.) |
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.
| Plan Type | Favors |
|---|---|
| Profit Sharing | Younger employees |
| 401(k) | Younger employees |
| Stock Bonus | Younger employees |
| ESOP | Younger employees |
| Money Purchase | Younger employees |
| Target Benefit | Older employees |
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
| Feature | Defined Benefit | Defined Contribution |
|---|---|---|
| What's Defined | Benefit | Contribution |
| Investment Risk | Employer | Employee |
| 2025 Limit | $280,000 benefit | $70,000 additions |
| Account Type | Commingled (accrued benefits) | Separate individual accounts |
| Favors | Older employees (except cash balance) | Younger employees (except target benefit) |
| PBGC | Yes (with exceptions) | No |
| Mandatory Funding | Yes | No (except pension plans) |
| Actuary Required | Yes | No (except target benefit at inception) |
| Prior Service Credit | Yes | No |
| QJSA/QPSA | Yes | No (unless plan distributes annuities) |
| Investment in ER Securities | Limited to 10% | Up to 100% |
Marcus, age 45, earns $200,000 annually. His employer contributes 15% of compensation to the profit sharing plan and allocates $4,000 in forfeitures to his account. Marcus also defers $23,500 to the 401(k). What is the total annual addition to his account in 2025?
An employee receives a lump-sum distribution of employer stock from a stock bonus plan. The employer's cost basis was $25,000 and the stock is worth $85,000 at distribution. What is the Net Unrealized Appreciation (NUA)?
Which statement about profit sharing plan contributions is correct?