Defined Benefits Plans
Defined benefit plans are designed to provide a specific benefit to an employee upon retirement. The amount of the benefit is usually dependent on length of service or highest salary earned or a combination of these. Deferred annuities are commonly used to fund defined benefit plans. These may be issued on a group or individual basis.

Two of the most common defined contribution plans are profit-sharing and pension plans.

Profit-Sharing Plans
A qualified profit-sharing plan must provide a definite, predetermined formula for allocating among plan participants the profits contributed to the plan. However the amount of annual contributions, if any, is usually left to the discretion of the employer. When the employee retires or leaves under certain other circumstances, the contributions that have been allocated to that employee, plus all earnings on them, are distributed to the employee.

Pension Plans
Pension plan benefits are generally measured by and based on such actors as years of service and compensation received. The determination of the amount of plan contributions or benefits is not based on the employer’s profits or left to the discretion of the employer. A money-purchase pension plan requires the employer to make a fixed contribution to the plan each year, which is then allocated among the plan participant’s accounts. At retirement an employee receives whatever benefit may be purchased with the money in his or her plan account. A target benefit pension plan is a cross between a defined contribution and defined benefit plan. The target benefit plan works much like a money-purchase plan except that a target benefit is specified. The target benefit plan also looks like a defined benefit plan, but it’s only a target and may or may not be reached.

401(k) Plans

Defined Benefits Plans When a profit-sharing or pension plan has been modified to provide a cash or deferred arrangement (CODA), the resulting plan is called a 401(k) plan after the section of the Internal Revenue Code that authorizes it. The term CODA refers to two different methods by which an employee can defer a portion of his or her pay into a 401(k) plan. In the classic case, the employee will be offered a cash bonus, all or part of which may be placed in, or deferred into, the plan on a before-tax basis. Alternately, the arrangement can take the form of a salary reduction agreement under which the employee elects to reduce his or her salary and place, or defer, the reduction portion into the plan, also on a before-tax basis. With either method, plan participants can avoid immediate taxation of the diverted bonus or salary deferral amount. Consequently, no income taxes are paid on these funds or their earnings until they are withdrawn.

Individual Retirement Accounts and Annuities—IRAs
The government offers individual retirement accounts and annuities (IRAs) so that people can plan for their own retirement. With an IRA, the amount an individual contributes may be deductible, within limitations, from gross income before taxable income is determined. The contribution limit will increase in future years. Table 14.1 shows the limits up to the year 2008.