Defined Benefit & Defined Contribution Plans

Chapter scope

We’ll cover the following workplace plans in this chapter:

• Qualified defined benefit plans
• Qualified defined contribution plans
• Non-qualified plans

🔑 Numbers, ages & limits

Master comparison — every workplace plan named

Qualified defined benefit plans

Defined benefit plans are qualified plans where the retirement benefit is specified (defined), but the employer’s contributions can vary over time. The most common defined benefit plan is a pension.

• Over the past several decades, pensions have fallen in popularity because they can be expensive and unpredictable for employers.
• Organizations that offer pensions are typically obligated to pay retired employees for life.
• 🔑 In many plans, an employee needs a long period of service (often 20 years or more) before they can receive pension benefits.

How the benefit is calculated

• Qualifying employees usually receive benefits based on salary during their working years.
• Example: an organization might offer a retirement benefit equal to 70% of the average of an employee’s top three years of earnings. If an employee’s top three years average $100,000, the employer pays $70,000 (70%) each year for life.
• Many pensions also include an annual cost-of-living adjustment to help keep up with inflation.
• 📌 Because benefits are tied to earnings, defined benefit plans tend to be most valuable for employees with higher salaries.

Employer obligation

• When the employee retires, they begin collecting payments from the former employer.
• Those payments must be made regardless of the employer’s financial condition. Even in a bad business year, the organization still has to pay retirees.
• This ongoing obligation is a major reason many corporations no longer offer pensions.
• Government-sponsored organizations (such as the military and police) are more likely to continue offering them.

Funding the obligation

Unfunded pension liability

An unfunded pension liability exists when projected future payouts exceed the amount expected to be set aside.

• Example: an organization projects $1 million in payouts in 2030 but expects only $800,000 in the pension fund at that time.
• If the shortfall isn’t addressed, the employer can eventually bankrupt itself.
• Many organizations maintain insurance backing their pensions to reduce retirees’ concern. If bankruptcy occurs, the insurance takes over the required payouts.

Qualified defined contribution plans

Defined contribution plans are qualified plans where the contribution amount is specified (defined), but the retirement benefit is unknown.

• Participating employees know what goes into the plan, but they don’t know what the account will be worth at retirement.
• Most defined contribution plans allow employees to contribute a set amount (for example, 7% of salary) and invest those contributions.
• Employers may also contribute on the employee’s behalf (for example, matching contributions up to 5% of salary).
• Because the account value depends on investment performance, the retirement benefit can vary.

Common tax structure

All of the plans discussed in this section follow the same general tax structure:

401(k) plans

• The 401(k) (named after section 401(k) of the Internal Revenue Code) is one of the most common qualified retirement plans.
• Available to private (non-government) for-profit companies; 401(k)s allow employees to contribute pre-tax money for retirement.
• Employers may also match employee contributions, which can accelerate the growth of retirement assets.
• Current employees generally can’t withdraw money from a 401(k), but they may qualify for a hardship withdrawal if they face financial problems.
• 🔑 Standard distribution rules still apply. If the employee is under age 59 ½, a distribution is generally subject to a 10% early withdrawal penalty plus ordinary income taxes.
• Once the employee is terminated (quits, is fired, or retires), they can access 401(k) funds, although taxes and some penalties may apply.
• 🔑 The 2026 employee contribution limit for 401(k) plans is $24,500.

Sidenote — Solo 401(k) plans

403(b) plans

• A 403(b) plan is similar to a 401(k), but it’s used by non-profit organizations, public school systems, and religious organizations.
• Sometimes called a tax-sheltered annuity.
• A 403(b) typically gives employees several options at retirement. The retiree can:
  • take money from the account,
  • roll it over to another retirement account, or
  • convert it into an annuity that pays income until death.
• 🔑 The 2026 employee contribution limit for 403(b) plans is $24,500.

Keogh (HR-10) plans

• HR-10 plans, also known as Keogh (pronounced key-o) plans, are designed for smaller professional practices (such as a dentist’s office or law firm).
• 🔑 The employer (for example, the dentist who owns the practice) has a 2026 contribution limit of $72,000 or 25% of income, whichever is less.
• ⚠️ A key rule: if the employer makes the maximum contribution for themselves, they must also make a matching contribution for eligible employees (such as dental hygienists) equal to 25% of each employee’s income.

Profit-sharing plans

• Profit-sharing plans do what the name suggests: the employer shares a portion of profits with employees by contributing to their retirement accounts.
• Example: a company might commit 10% of its profits to employees’ profit-sharing plans.
• Employees don’t contribute to these plans, and the employer isn’t obligated to contribute every year.
• If the business has no profits, there’s nothing to share. Even if the company is profitable, the employer can choose not to contribute in a given year.
• This flexibility can help employers manage cash flow while still offering an incentive tied to company performance.

Money purchase plans

Money purchase plans are similar to profit-sharing plans, with two key differences:

• Example: a company might contribute 4% of each employee’s salary annually.
• Some money purchase plans allow employees to contribute in addition to the employer’s contribution, but plans that do typically require employee contributions to be made annually.

SEP & SIMPLE IRAs

• Later in this unit, you’ll learn about individual retirement accounts (IRAs). IRAs aren’t always employer-sponsored, but SEP IRAs and SIMPLE IRAs are.
• Self-employed pension (SEP) IRAs and savings incentive match for employees (SIMPLE) IRAs are designed for smaller companies.
• They are similar to Keogh plans, but with minor differences you won’t need to know for the exam.
• 📌 “You shouldn’t expect specific test questions on their contribution limits, but you may need to know that their limits are higher than traditional and Roth IRA contribution limits (discussed later).”

Sidenote — RMD delays for older workers

• 🔑 While required minimum distributions (RMDs) apply to qualified plans, individuals age 73 or older who are still working can delay RMDs indefinitely — but only for the qualified plan at their current place of employment.
• Example: Parsa is 78 years old and works for a corporation that offers a 401(k) plan. Although Parsa is above the age 73 threshold, he isn’t subject to RMDs from that 401(k) until he retires.

Non-qualified plans

• Non-qualified plans are not governed by the Employee Retirement Income Security Act (ERISA). That means they don’t have to follow the ERISA rules discussed in the previous chapter.
• ⚠️ One advantage of not being ERISA-governed is the ability to discriminate, meaning the employer can choose who is offered the plan.
• Qualified plans generally must be offered to all full-time employees, but non-qualified plans can be offered only to executives, officers, directors, or any other selected group.

Deferred compensation plans

• A common type of non-qualified plan is a deferred compensation plan.
• These plans promise compensation in the future and are typically offered to higher-level employees with large salaries.
• Example: if an employee earns $500,000 annually, they might defer $100,000, invest those funds, and then receive the basis (amount invested) and growth in retirement.
• The employee generally pays taxes on the compensation when it’s received later, which reduces taxable income in the year the salary is deferred.

plans

• A 457 plan is another type of non-qualified plan available only to government employees and certain non-profit organization employees.
• ⚠️ It’s unique among non-qualified plans because it allows tax-deductible contributions and tax-deferred growth.
• ⚠️ Unlike most other retirement plans, early withdrawal penalties do not apply to 457 plans.
• 🔑 The 2026 contribution limit for 457 plans is $24,500.

Key points

ERISA

• Legislation governing qualified plans

General ERISA requirements

ERISA Section 404(c) — Provides liability shield to plan fiduciaries if certain protocols are followed:

• Make proper plan disclosures
• Offer at least three investment choices
• Allow quarterly investment portfolio changes

Defined benefit plans

• Varying contributions made over time
• Defined retirement benefit
• Most beneficial for employees:
  • With higher salaries
  • Closest to retirement age

Pensions

• Common form of defined benefit plan
• Pay retirement income until death

Unfunded pension liabilities

• Payouts exceed assets (forecasted)

Defined contribution plans

• Defined contributions
• Unknown benefit at retirement

Plan-by-plan key points

Sources

Primary/official references for the material in this chapter. Every link was fetched and returned HTTP 200 on 2026-08-15.