A defined contribution plan defines the contribution the company will make to the plan and how the contribution will be allocated among the eligible employees. Separate account balances are maintained for each employee. The employee's account grows through employer contributions, investment earnings and, in some cases, forfeitures (amounts from the non-vested accounts of terminated participants). Some plans may also permit employees to make contributions on a before-and/or after-tax basis.
Since the contributions, investment results and forfeiture allocations vary year by year, the future retirement benefit cannot be predicted. The employee's retirement, death or disability benefit is based upon the amount in his account at the time the distribution is payable.
Employer account balances may be subject to a vesting schedule. Non-vested account balances forfeited by terminating employees can be used to reduce employer contributions or be reallocated to active participants.The maximum annual amount that may be credited to an employee's account (taking into consideration all defined contribution plans sponsored by the employer) is limited to the lesser of 100% of compensation or $54,000 for 2017 and $55,000 for 2018.
The maximum employer tax deduction limit must also be taken into consideration. Employer contributions cannot exceed 25% of the total compensation of all eligible employees. For example, a company with only one employee earning $100,000 in 2017 would have a maximum deductible employer contribution of $25,000 (25% of $100,000). However, the employee could also make a $18,000 401(k) contribution to the plan. As a result the total amount credited to his account for the year would be $43,000 (43% of his compensation), and he would satisfy the 2017 maximum annual limit since total contributions are less than $54,000.