Defined Benefits Plans - Q&A

Questions & Answers

  • Which employees must you include in your defined benefit plan?
  • When does plan participation begin?
  • What is minimum coverage testing?
  • What is a highly compensated employee?
  • How is compensation defined?
  • When do employees have part or full ownership (i.e., vesting) of their defined benefit accounts?
  • What happens if your defined benefit plan investments do better than expected and are more than necessary to pay the promised benefit?
  • Do you need to receive a favorable determination letter from the IRS in order for your plan to be qualified?
  • What happens if the IRS determines that your defined benefit plan no longer meets the qualified plan requirements?

Which employees must you include in your defined benefit plan?

Generally, plan participation must be offered to all employees who are at least 21 years of age and who worked at least 1,000 hours for the employer in a previous year. Two years of service may be required for participation as long as the employee will be 100 percent vested immediately when he or she enters the plan. You can impose less (but not more) restrictive requirements.

In addition, your defined benefit plan must meet minimum participation requirements regarding the number of employees who must participate in the plan. Specifically, on each day of the plan year, a defined benefit plan must benefit at least the lesser of (1) 50 employees, or (2) the greater of:

  • 40 percent of all employees, or
  • 2 employees

But if there is only one employee, the plan must benefit that employee.

Tip: State and local government plans are exempt from the minimum participation requirements.

When does plan participation begin?

An employee who meets the minimum age and service requirements of the plan must be allowed to participate no later than the earlier of:

  • The first day of the plan year beginning after the date the employee met the age and service requirements, or
  • The date six months after these conditions are met

What is minimum coverage testing?

In general, to be qualified (i.e., tax favored), a plan must meet employee coverage tests that demonstrate that the plan does not discriminate in favor of highly compensated employees. A plan that covers highly compensated employees must also cover a certain minimum number (or percentage) of the non-highly-compensated employees.

There are several coverage tests. Under the most basic minimum coverage test, a plan may cover any or all of the highly compensated employees if it also covers a number of non-highly-compensated employees equal to at least 70 percent of the percentage of highly compensated employees covered.

For example, if the plan covers 100 percent of the highly compensated employees, then the plan must also cover at least 70 percent of the non-highly-compensated employees of the employer. Or, if the plan covers only 50 percent of the highly compensated employees, then the plan must also cover at least 35 percent of the non-highly-compensated employees of the employer (70 percent of 50 percent equals 35 percent).

For more information, consult an attorney or retirement plan specialist.

Tip: State and local government plans are exempt from the minimum coverage requirements.

What is a highly compensated employee?

For 2022, a highly compensated employee is an individual who:

  • Was a 5 percent ownership of the employer during 2021 or 2022, or
  • Had compensation in 2022 in excess of $135,000 and, at the election of the employer, was in the top 20 percent of employees in terms of compensation for that year. (This $135,000 limit is subject to cost of living adjustments each year.)

How is compensation defined?

For purposes of determining who is a highly compensated employee, compensation includes all taxable personal services income–such as wages, salaries, fees, commissions, bonuses, and tips–and also includes elective or salary reduction contributions to cafeteria and salary deferral plans such as 401(k) plans.

When do employees have part or full ownership (i.e., vesting) of their defined benefit accounts?

Employer contributions in general either must vest 100 percent after five years of service (“cliff” vesting), or must gradually vest with 20 percent after three years of service, followed by 20 percent per year until 100 percent vesting is achieved after seven years (“graded” or “graduated” vesting). Top-heavy plans, however, must have either 100 percent three-year cliff vesting or six-year graduated vesting. Finally, plans that require two years of service before employees are eligible to participate must vest 100 percent after two years of service.

What happens if your defined benefit plan investments do better than expected and are more than necessary to pay the promised benefit?

If the account becomes overfunded, your employer contributions must be suspended for a period of time.

Do you need to receive a favorable determination letter from the IRS in order for your plan to be qualified?

No, a plan does not need to receive a favorable IRS determination letter in order to be qualified. If the plan provisions (both the written provisions and as implemented) meet IRC and ERISA requirements, the plan is qualified and entitled to the appropriate tax benefits. Nevertheless, without a determination letter, the issue of plan qualification for a given year does not arise until the IRS audits your tax returns for that year. By that time, however, it is generally too late for you to amend your plan to correct any disqualifying provisions. Consequently, a determination letter helps to avoid this problem, because auditing agents generally won’t raise the issue of plan qualification with respect to the “form” of the plan (as opposed to its “operation”) if you have a current favorable determination letter.

What happens if the IRS determines that your defined benefit plan no longer meets the qualified plan requirements?

The IRS has established programs for plan sponsors to correct defects. These programs are designed to allow correction with sanctions that are less severe than outright disqualification. If, however, you are unable to correct the defects in your program appropriately, your plan may be disqualified. Loss of a plan’s qualified status results in the following consequences:

  • Employees could be taxed on their accrued benefits when they vest, rather than when benefits are paid
  • Your deduction for employer contributions may be deferred
  • The plan trust would have to pay taxes on its earnings
  • Distributions from the plan become ineligible for special tax treatment and cannot be rolled over tax free