Key Points
Overview
Historically, qualified retirement plans were divided into two basic types: pension plans and profit-sharing plans. In 1974, the Employee Retirement Income Security Act (ERISA) introduced new classifications. Today, qualified plans are commonly categorized as either defined contribution plans or defined benefit plans. The distinction rests on how the plan benefits are determined:
- Under defined contribution plans, the employer’s contribution rate is defined.
- Under defined benefit plans, the employee’s retirement benefit is defined.
Jerry Nelson is covered by his company’s qualified plan. The plan provides that the employer will regularly contribute an amount equal to 10% of each plan participant’s salary. Nelson participates in a defined contribution plan — the contribution rate is fixed, but the eventual benefit depends on investment performance.
Example — Defined BenefitAmy Thompson is covered by her company’s qualified plan. The plan provides that upon normal retirement age, each participant will receive an annual retirement benefit equal to 40% of compensation. Thompson participates in a defined benefit plan — the benefit is fixed; the employer’s required contributions are determined actuarially.
Defined Contribution Plans
Under a defined contribution plan, the participant’s ultimate retirement benefit is determined by:
- employer contributions,
- employee contributions,
- investment gains and losses,
- forfeitures allocated to remaining participants, and
- plan administrative expenses.
The following types of plans are treated as defined contribution plans:
- money purchase plans,
- target benefit plans,
- profit-sharing plans,
- stock bonus plans,
- 401(k) plans,
- employee stock ownership plans (ESOPs), and
- thrift or savings plans.
The annual additions limit for all defined contribution plans is $72,000 (2026), or 100% of the participant’s compensation if less. The compensation cap used in benefit calculations is $360,000 (2026).
An employer maintaining a money purchase plan has a fixed obligation to make contributions each year, regardless of profits or losses. The employer’s annual contribution is tax-deductible as a business expense. The contribution is typically a fixed percentage of each participant’s compensation, and the employee receives whatever retirement benefit can be purchased with the accumulated savings.
A money purchase plan provides an employer contribution of 20% of each participant’s compensation. If the participant earns $40,000 a year, the employer contributes $8,000 (20% × $40,000) to that participant’s account each year.
Target benefit plans are hybrids — a cross between defined benefit and money purchase plans. The employer sets a target retirement benefit for each participant to determine the initial contribution. After the initial contribution, no further actuarial assumptions are made. The employer makes a fixed annual contribution, and the participant’s actual retirement benefit is determined by what accumulates in his or her account. The actual benefit may be more or less than the original target.
A target benefit plan provides a target benefit equal to 15% of each participant’s compensation. If the participant earns $20,000 a year, the target retirement benefit is $3,000 (15% × $20,000). In the first year, the employer makes a contribution designed to fund this target benefit. For subsequent years, the contribution rate remains fixed and is not adjusted for actuarial changes.
Profit-sharing plans do not provide fixed contributions or benefits. Instead, they give employees the opportunity to share in the profits of the employer. The plan must provide a formula for allocating employer contributions among participants. However, the actual amount of any contribution is generally left to the employer’s discretion. In a good year the employer may contribute generously; in a poor year the employer may contribute nothing at all.
The purpose of a stock bonus plan is to give employees an ownership stake in the company through stock ownership. Employer contributions may, but do not have to, be related to the profits of the company. Distributions are generally made in the form of employer stock.
When a profit-sharing plan provides a cash or deferred arrangement (CODA), the plan is commonly called a 401(k) plan — named after the section of the Internal Revenue Code that authorized it. As a general rule, employees defer a portion of their salary to the plan under a salary reduction agreement. The 2026 elective deferral limit is $24,500, with a catch-up of $8,000 for those age 50–59 and 64+, and a super catch-up of $11,250 for those age 60–63 (SECURE Act 2.0).
Employee Stock Ownership Plans (ESOPs) are a form of defined contribution plan that contributes the employer’s stock — rather than cash — to participant accounts. ESOPs are subject to special rules regarding diversification rights, distribution requirements, and leveraging. The 2026 ESOP account balance limit subject to a five-year distribution period is $1,455,000.
Savings or thrift plans reward employees for their thrift by providing employer matching contributions for employee contributions to the plan. These plans encourage employee savings by matching all or part of what the employee puts in.
Although Simplified Employee Pensions (SEPs) are not considered qualified plans, they are subject to many of the same rules as defined contribution plans. SEP plans are special IRA arrangements that allow an employer to contribute increased amounts to its employees’ IRAs. The SEP contribution limit is the lesser of 25% of compensation or $72,000 (2026), with the compensation cap at $360,000.
Defined Benefit Plans
As the name implies, in a defined benefit plan the employee’s retirement benefit is defined. The employer’s required contribution is not fixed — it is determined actuarially based on what is needed to fund the promised benefit. The 2026 annual benefit limit for defined benefit plans is $290,000.
A defined benefit plan provides that each participant will receive an annual retirement benefit equal to 25% of compensation. If the employee earns $30,000 a year, the employer must make contributions sufficient to fund the promised $7,500 annual benefit (25% × $30,000).
The size of the employer’s annual contribution is based on actuarial assumptions including future interest rates, salary changes, investment gains and losses, mortality, and employee turnover. Because these factors change, the employer must adjust annual contributions accordingly. Defined benefit plans are more costly to operate because an actuary must be hired each year to determine the required contribution.
Pension Plans and Profit-Sharing Plans
Historically, retirement plans were classified as pension or profit-sharing plans. Although most tax rules are geared to the defined contribution / defined benefit distinction, some rules still apply specifically to the pension / profit-sharing classification.
- Pension plans provide for the payment of definitely determinable benefits — either fixed benefits or fixed contributions. Pension plans include defined benefit plans, money purchase plans, and target benefit plans.
- Profit-sharing plans do not provide for fixed benefits or contributions. Instead, the employer agrees to make contributions out of annual profits.
In summary: defined benefit plans are always classified as pension plans. Defined contribution plans may be either pension or profit-sharing.
| Historical Classification | Plan Types | Modern Classification |
|---|---|---|
| Profit-Sharing Plans | Profit-Sharing Plans | Defined Contribution Plans |
| SEPs | ||
| 401(k) Plans | ||
| Stock Bonus Plans | ||
| ESOPs | ||
| Pension Plans | Money Purchase Plans | |
| Target Benefit Plans | ||
| Pension Plans | Defined Benefit Plans | Defined Benefit Plans |
Plan Qualification Requirements
To receive favorable tax treatment, a qualified plan must comply with numerous IRS requirements. The law provides that a qualified plan must:
- be established and maintained for the exclusive benefit of employees (and their beneficiaries),
- provide non-assignable benefits — employees cannot assign or pledge their plan benefits,
- be in writing and communicated to employees,
- meet minimum participation requirements,
- provide contributions and benefits that do not discriminate in favor of higher-paid employees,
- provide contributions and benefits that do not exceed legal limits (see 2026 limits in Chapter 1),
- meet minimum vesting requirements,
- provide proper distributions and automatic survivor benefits,
- allow for rollover of benefits to another qualified plan or IRA, and
- meet special top-heavy rules (plans that disproportionately benefit key employees face additional contribution requirements).
At the heart of these requirements is the concept that qualified plans cannot discriminate in favor of highly compensated employees (HCEs). Most rules are aimed at prohibiting discrimination. As a result, qualified plans must offer essentially the same benefits to rank-and-file employees as are offered to HCEs.
Typically, employers want to limit participation or provide greater benefits to owners and key employees. To a limited degree, this can be accomplished by limiting participation, setting contribution formulas, or through vesting schedules, integration with Social Security, or the selection of the plan type itself. However, in most cases, a qualified plan will cover a broader group of employees than the employer might prefer — adding cost. If an employer is not willing to extend benefits to all those required under a qualified plan, a non-qualified plan may be more appropriate.
Summary
Qualified plans are categorized as defined contribution or defined benefit. Under defined contribution plans, the contribution is fixed; the benefit varies with investment performance. Under defined benefit plans, the promised benefit is fixed; the required employer contribution is determined annually by an actuary.
Common defined contribution plan types include money purchase, profit-sharing, 401(k), stock bonus, ESOPs, and thrift plans. Defined benefit plans always fall under the pension classification; defined contribution plans may be either pension or profit-sharing.
All qualified plans must meet IRS qualification requirements designed to prevent discrimination in favor of highly compensated employees. These requirements cover participation, vesting, contributions, benefits, distributions, and top-heavy rules.