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.

Set-up deadline.   To take a deduction for contributions for a tax year, your plan must be set up (adopted) by the last day of that year (December 31 for calendar year employers).

Credit for startup costs.   You may be able to claim a tax credit for part of the ordinary and necessary costs of starting a qualified plan that first became effective in 2004. For more information, see Credit for startup costs under Reminders, earlier.

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.

Internal Revenue Bulletins are available on the IRS website at www.irs.gov. They are also available at most IRS offices and at certain libraries.

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.

Quarterly installments of required contributions.   If your plan is a defined benefit plan subject to the minimum funding requirements, you must make quarterly installment payments of the required contributions. If you do not pay the full installments timely, you may have to pay interest on any underpayment for the period of the underpayment.

Due dates.   The due dates for the installments are 15 days after the end of each quarter. For a calendar-year plan, the installments are due April 15, July 15, October 15, and January 15 (of the following year).

Installment percentage.   Each quarterly installment must be 25% of the required annual payment.

Extended period for making contributions.   Additional contributions required to satisfy the minimum funding requirement for a plan year will be considered timely if made by 8½ months after the end of that year.

Contributions deadline.   You can make deductible contributions for a tax year up to the due date of your return (plus extensions) for that year.

Self-employed individual.   You can make contributions on behalf of yourself only if you have net earnings (compensation) from self-employment in the trade or business for which the plan was set up. Your net earnings must be from your personal services, not from your investments. If you have a net loss from self-employment, you cannot make contributions for yourself for the year, even if you can contribute for common-law employees based on their compensation.

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 Notice 98-1 for further guidance and transition relief relating to the nondiscrimination rules under sections 401(k) and 401(m). Notice 98-1 is in Cumulative Bulletin 1998-1.

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

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, Form 1120-A, U.S. Corporation Short-Form 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 32 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, Credits, Deductions, 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.

Automatic enrollment in a 401(k) plan.   Your 401(k) plan can have an automatic enrollment feature. Under this feature, you can automatically reduce an employee's pay by a fixed percentage and contribute that amount to the 401(k) plan on his or her behalf unless the employee affirmatively chooses not to have his or her pay reduced or chooses to have it reduced by a different percentage. These contributions qualify as elective deferrals. For more information about 401(k) plans with an automatic enrollment feature, see Revenue Ruling 2000-8 in Cumulative Bulletin 2000-1.

Partnership.   A partnership can have a 401(k) plan.

Restriction on conditions of participation.   The plan cannot require, as a condition of participation, that an employee complete more than 1 year of service.

Matching contributions.   If your plan permits, you can make matching contributions for an employee who makes an elective deferral to your 401(k) plan. For example, the plan might provide that you will contribute 50 cents for each dollar your participating employees choose to defer under your 401(k) plan.

Nonelective contributions.   You can, under a qualified 401(k) plan, also make contributions (other than matching contributions) for your participating employees without giving them the choice to take cash instead.

Employee compensation limit.   No more than $205,000 of the employee's compensation can be taken into account when figuring contributions.

SIMPLE 401(k) plan.   If you had 100 or fewer employees who earned $5,000 or more in compensation during the preceding year, you may be able to set up a SIMPLE 401(k) plan. A SIMPLE 401(k) plan is not subject to the nondiscrimination and top-heavy plan requirements discussed later under Qualification Rules. For details about SIMPLE 401(k) plans, see SIMPLE 401(k) Plan in chapter 3.

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 2004, the basic limit on elective deferrals is $13,000. (For 2005, this limit increases to $14,000.) 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 2004, 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, 2005 (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, 2005.

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.

Certain distributions listed above may be subject to the tax on early distributions discussed later.

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 next under Rollover.

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 Publication 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.

A distribution of the employee's nondeductible contributions may qualify as a rollover distribution. The transfer must be made either (1) through a direct rollover to a defined contribution plan that separately accounts for the taxable and nontaxable parts of the rollover or (2) through a rollover to a traditional IRA.

If a distribution is made to an employee under the plan before he or she reaches age 59½, the employee may have to pay a 10% additional tax on the distribution. This tax applies to the amount received that the employee must include in income.

If you are or have been a 5% owner of the business maintaining the plan, amounts you receive at any age that are more than the benefits provided for you under the plan formula are subject to an additional tax. This tax also applies to amounts received by your successor. The tax is 10% of the excess benefit includible in income.

A 20% or 50% excise tax is generally imposed on the cash and fair market value of other property an employer receives directly or indirectly from a qualified plan. If you owe this tax, report it in Part IX of Form 5330. See the form instructions for more information.

An employer or the plan will have to pay an excise tax if both the following occur.

A plan amendment that eliminates or reduces any early retirement benefit or retirement-type subsidy reduces the rate of future benefit accrual.

The notice must be written in a manner calculated to be understood by the average plan participant and must provide enough information to allow each individual to understand the effect of the plan amendment. It must be provided within a reasonable time before the amendment takes effect.

The tax is $100 per participant or alternate payee for each day the notice is late. It is imposed on the employer, or, in the case of a multi-employer plan, on the plan.

There are certain exceptions to, and limitations on, the tax. The tax does not apply in any of the following situations.

If the person liable for the tax exercised reasonable diligence to meet the notice requirement, the tax cannot be more than $500,000 during the tax year. The tax can also be waived to the extent it would be excessive or unfair if the failure is due to reasonable cause and not to willful neglect.

Exemption.   Certain transactions are exempt from being treated as prohibited transactions. For example, a prohibited transaction does not take place if you are a disqualified person and receive any benefit to which you are entitled as a plan participant or beneficiary. However, the benefit must be figured and paid under the same terms as for all other participants and beneficiaries. For other transactions that are exempt, see section 4975 and the related regulations.

Disqualified person.   You are a disqualified person if you are any of the following.

The initial tax on a prohibited transaction is 15% of the amount involved for each year (or part of a year) in the taxable period. If the transaction is not corrected within the taxable period, an additional tax of 100% of the amount involved is imposed. For information on correcting the transaction, see Correcting a prohibited transaction, later.

Both taxes are payable by any disqualified person who participated in the transaction (other than a fiduciary acting only as such). If more than one person takes part in the transaction, each person can be jointly and severally liable for the entire tax.

Form 5500-EZ.   You can use Form 5500-EZ if the plan meets all the following conditions.

One-participant plan.   Your plan is a one-participant plan if either of the following is true.

Form 5500-EZ not required.   You do not have to file Form 5500-EZ (or Form 5500) if you meet the conditions mentioned above and either of the following conditions.

  

All one-participant plans must file Form 5500-EZ for their final plan year, even if the total plan assets have always been less than $100,000. The final plan year is the year in which distribution of all plan assets is completed.

Form 5500.   If you do not meet the requirements for filing Form 5500-EZ, you must file Form 5500.

Schedule A (Form 5500).   If any plan benefits are provided by an insurance company, insurance service, or similar organization, complete and attach Schedule A (Form 5500) to Form 5500. Schedule A is not needed for a plan that covers only one of the following.

  

Do not file a Schedule A (Form 5500) with a Form 5500-EZ.

Schedule B (Form 5500).   For most defined benefit plans, complete and attach Schedule B (Form 5500), Actuarial Information, to Form 5500 or Form 5500-EZ.

Schedule P (Form 5500).   This schedule is used by a fiduciary (trustee or custodian) of a trust described in section 401(a) or a custodial account described in section 401(f) to protect it under the statute of limitations provided in section 6501(a). The filing of a completed Schedule P (Form 5500), Annual Return of Fiduciary of Employee Benefit Trust, by the fiduciary satisfies the annual filing requirement under section 6033(a) for the trust or custodial account created as part of a qualified plan. This filing starts the running of the 3-year limitation period that applies to the trust or custodial account. For this protection, the trust or custodial account must qualify under section 401(a) and be exempt from tax under section 501(a). The fiduciary should file, under section 6033(a), a Schedule P as an attachment to Form 5500 or Form 5500-EZ for the plan year in which the trust year ends. The fiduciary cannot file Schedule P separately. See the Instructions for Form 5500 for more information.

Form 5310.   If you terminate your plan and are the plan sponsor or plan administrator, you can file Form 5310, Application for Determination for Terminating Plan. Your application must be accompanied by the appropriate user fee and Form 8717, User Fee for Employee Plan Determination Letter Request.

More information.   For more information about reporting requirements, see the forms and their instructions.

Plan assets must not be diverted.   Your plan must make it impossible for its assets to be used for, or diverted to, purposes other than the benefit of employees and their beneficiaries. As a general rule, the assets cannot be diverted to the employer.

Minimum coverage requirement must be met.   To be a qualified plan, a defined benefit plan must benefit at least the lesser of the following. If there is only one employee, the plan must benefit that employee.

Contributions or benefits must not discriminate.   Under the plan, contributions or benefits to be provided must not discriminate in favor of highly compensated employees.

Contributions and benefits must not be more than certain limits.   Your plan must not provide for contributions or benefits that are more than certain limits. The limits apply to the annual contributions and other additions to the account of a participant in a defined contribution plan and to the annual benefit payable to a participant in a defined benefit plan. These limits were discussed earlier under Contributions.

Minimum vesting standard must be met.   Your plan must satisfy certain requirements regarding when benefits vest. A benefit is vested (you have a fixed right to it) when it becomes nonforfeitable. A benefit is nonforfeitable if it cannot be lost upon the happening, or failure to happen, of any event.

Participation.   In general, an employee must be allowed to participate in your plan if he or she meets both the following requirements.

Leased employee.   A leased employee, defined in chapter 1, who performs services for you (recipient of the services) is treated as your employee for certain plan qualification rules. These rules include those in all the following areas. Contributions or benefits provided by the leasing organization for services performed for you are treated as provided by you.

Benefit payment must begin when required.   Your plan must provide that, unless the participant chooses otherwise, the payment of benefits to the participant must begin within 60 days after the close of the latest of the following periods.

Early retirement.   Your plan can provide for payment of retirement benefits before the normal retirement age. If your plan offers an early retirement benefit, a participant who separates from service before satisfying the early retirement age requirement is entitled to that benefit if he or she meets both the following requirements.

Survivor benefits.   Defined benefit and money purchase pension plans must provide automatic survivor benefits in both the following forms.

  The automatic survivor benefit also applies to any participant under a profit-sharing plan unless all the following conditions are met.

Loan secured by benefits.   If survivor benefits are required for a spouse under a plan, he or she must consent to a loan that uses as security the accrued benefits in the plan.

Waiver of survivor benefits.   Each plan participant may be permitted to waive the joint and survivor annuity or the pre-retirement survivor annuity (or both), but only if the participant has the written consent of the spouse. The plan also must allow the participant to withdraw the waiver. The spouse's consent must be witnessed by a plan representative or notary public.

Waiver of 30-day waiting period before annuity starting date.    A plan may permit a participant to waive (with spousal consent) the 30-day minimum waiting period after a written explanation of the terms and conditions of a joint and survivor annuity is provided to each participant.

  The waiver is allowed only if the distribution begins more than 7 days after the written explanation is provided.

Involuntary cash-out of benefits not more than dollar limit.   A plan may provide for the immediate distribution of the participant's benefit under the plan if the present value of the benefit is not greater than $5,000.

  However, the distribution cannot be made after the annuity starting date unless the participant and the spouse or surviving spouse of a participant who died (if automatic survivor benefits are required for a spouse under the plan) consents in writing to the distribution. If the present value is greater than $5,000, the plan must have the written consent of the participant and the spouse or surviving spouse (if automatic survivor benefits are required for a spouse under the plan) for any immediate distribution of the benefit.

  Benefits attributable to rollover contributions and earnings on them can be ignored in determining the present value of these benefits.

  For distributions made on or after March 28, 2005, a plan must provide for the automatic rollover of any cash-out distribution of more than $1,000 to an individual retirement account, unless the participant chooses otherwise. The plan administrator must notify the participant in writing that the distribution can be transferred to another IRA.

Consolidation, merger, or transfer of assets or liabilities.   Your plan must provide that, in the case of any merger or consolidation with, or transfer of assets or liabilities to, any other plan, each participant would (if the plan then terminated) receive a benefit equal to or more than the benefit he or she would have been entitled to just before the merger, etc. (if the plan had then terminated).

Benefits must not be assigned or alienated.   Your plan must provide that its benefits cannot be assigned or alienated.

Exception for certain loans.   A loan from the plan (not from a third party) to a participant or beneficiary is not treated as an assignment or alienation if the loan is secured by the participant's accrued nonforfeitable benefit and is exempt from the tax on prohibited transactions under section 4975(d)(1) or would be exempt if the participant were a disqualified person. A disqualified person is defined earlier under Prohibited Transactions.

Exception for qualified domestic relations order (QDRO).   Compliance with a QDRO does not result in a prohibited assignment or alienation of benefits. QDRO is defined in Publication 575.

  Payments to an alternate payee under a QDRO before the participant attains age 59½ are not subject to the 10% additional tax that would otherwise apply under certain circumstances. The interest of the alternate payee is not taken into account in determining whether a distribution to the participant is a lump-sum distribution. Benefits distributed to an alternate payee under a QDRO can be rolled over tax free to an individual retirement account or to an individual retirement annuity.

No benefit reduction for social security increases.   Your plan must not permit a benefit reduction for a post-separation increase in the social security benefit level or wage base for any participant or beneficiary who is receiving benefits under your plan, or who is separated from service and has nonforfeitable rights to benefits. This rule also applies to plans supplementing the benefits provided by other federal or state laws.

Elective deferrals must be limited.   If your plan provides for elective deferrals, it must limit those deferrals to the amount in effect for that particular year. See Limit on Elective Deferrals, earlier.

Top-heavy plan requirements.   A top-heavy plan is one that mainly favors partners, sole proprietors, and other key employees.

  A plan is top heavy for any plan year for which the total value of accrued benefits or account balances of key employees is more than 60% of the total value of accrued benefits or account balances of all employees. Additional requirements apply to a top-heavy plan primarily to provide minimum benefits or contributions for non-key employees covered by the plan.

  Most qualified plans, whether or not top heavy, must contain provisions that meet the top-heavy requirements and will take effect in plan years in which the plans are top heavy. These qualification requirements for top-heavy plans are explained in section 416 and its regulations.

SIMPLE and safe harbor 401(k) plan exception.   The top-heavy plan requirements do not apply to SIMPLE 401(k) plans or to safe harbor 401(k) plans that consist solely of safe harbor contributions.