Defined Benefits Plans

If you’d like a retirement plan that guarantees a specified benefit level at retirement regardless of investment results, you may want to consider a defined benefit pension plan. A defined benefit plan is a qualified employer-sponsored retirement plan that is funded solely by the employer (in most cases); it’s the traditional type of pension plan. A defined benefit pension plan allows the highest potential contribution amount of any plan. These contributions are excluded from income and grow tax deferred. In addition, contributions can be deducted from business income.

Tip: Generally, a defined benefit plan is most favorable for an employer that wants to maximize tax-deferred retirement savings for its older, long-term employees and that can afford to make large contributions.

Who can establish a defined benefit plan?

Just about any employer can set up a defined benefit pension plan for its employees. Still, this type of plan is most attractive to employers that have a small group of highly compensated owners (and no employees) who are seeking to contribute as much money as possible on a tax-deferred basis. That’s because the plan allows large deductions, and most of the current contributions generally will be used to fund benefits for high-paid, older principals.

Tip: If you have younger employees, relatively little will be required currently to fund benefits for them. Because young employees have many years to accumulate their retirement benefits, relatively smaller current contributions are needed.

Tip: Traditional defined benefit pension plans are less common among employers than they used to be. As part of the corporate trend toward downsizing and cost cutting, some companies have eliminated these employer-funded plans in favor of 401(k)s and other defined contribution plans that are funded largely (or solely) through employee contributions. Other companies are converting their traditional defined benefit pension plans into “cash balance” plans, which have certain advantages for employees (e.g., portability in the event of a job change).

Tip: Sole proprietors and other small business owners may also be interested in Section 412(E)(3) defined benefit plans, which can produce larger initial deductions and simpler plan administration. See Questions & Answers for more information.

How are employees’ benefits determined and paid?

Under a defined benefit plan, the amount of each employee’s future retirement benefit is determined by using a specific formula set forth in the plan. The formula generally bases each employee’s benefit on his or her compensation, age, length of service with the employer, or some combination thereof. In some cases, for example, the calculation of benefits may be as simple as multiplying the employee’s number of years of service (up to a stated maximum number) by a flat dollar amount. More often, though, a defined benefit formula weighs an employee’s final few years before retirement more heavily than the preceding years. For instance, an employer may promise to pay each employee an annual retirement benefit equal to a certain percentage of the employee’s final three-year average salary.

As employees retire, their benefits are paid to them from a pension trust fund that is used to hold all of the plan’s assets. (In addition to retirement benefits, survivor benefits and/or disability benefits may be paid from the trust fund.) This is in sharp contrast to a defined contribution plan, such as a 401(k) plan. Typically, such plans give each participant an individual account whose value at retirement depends on both contributions made and the performance of plan investments.

What are some advantages offered by defined benefit plans?

You can make higher contributions to a defined benefit plan than to any other plan.

An actuary determines the appropriate contribution amount to ensure the guaranteed future payout. Your payout generally depends on such factors as your salary, age, and years of service with the company. For a benefit beginning at age 65, a participant can have an annual lifetime retirement benefit that is the lesser of (1) $245,000 (in 2022) (the “dollar limit”), or (2) 100 percent of the participant’s compensation averaged over his or her three highest-earning consecutive years (the “compensation limit”). (The dollar limit will be reduced for employees retiring prior to age 62, and increased for those retiring after age 65.) The compensation limit does not apply to an employee whose annual benefit is $10,000 or less, if certain conditions are satisfied.

The plan provides a guaranteed pension benefit

Benefits do not hinge on the performance of underlying investments. Instead, each participant receives the amount guaranteed under the plan. Retirement benefits are based on a formula. This formula can provide for a set dollar amount for each year you work for the employer, or it can provide for a specified percentage of earnings. An actuary determines the appropriate contribution amount to ensure the guaranteed payout. If, during the course of the plan, it appears that this amount is not going to be adequately funded, the actuary must recalculate the contributions necessary to ensure that the guaranteed benefit can be paid.

Your contributions are tax deductible

You may deduct contributions to the plan from your business’s income in the year in which you make them.

Your contributions are tax deferred for your employees

Contributions and earnings on plan assets are nontaxable to plan participants until plan distributions are made.

Your plan may be “integrated” with Social Security

Basically, this means that you can (within specific limits) allow your plan to pay more to higher-paid employees. This is because benefits provided by a qualified retirement plan and those provided by Social Security are viewed by the IRS as one retirement program. Because Social Security provides a higher percentage-of-salary benefit to lower-paid employees, the IRS allows a qualified retirement plan to favor higher-paid employees within specific limits (this is referred to as “permitted disparity.”)

Loans can be made available to participants

A defined benefit plan can be set up to allow participants to take loans from the plan. However, loans are often not permitted because they can be administratively burdensome. Generally, participant loans must meet the following conditions:

  • They must not be made available to highly compensated employees in an amount greater than that available to other employees
  • They must be made in accordance with specific loan provisions set forth in the plan
  • They must carry a reasonable interest rate
  • They must be adequately secured

What are some disadvantages associated with defined benefit plans?

You must make periodic payments to the plan regardless of whether your business is making a profit

Regardless of how your business is performing, you must fund your traditional defined benefit plan on a quarterly or more frequent installment basis. Consequently, you should not establish a defined benefit plan if you have a business that might not have the cash to fund the plan in future years. You may be subject to substantial penalties by the IRS if you underfund the plan.

You must hire an actuary to determine how much you must contribute to the plan

In order to operate a traditional defined benefit pension plan, you must enlist the services of an actuary to calculate how much you must deposit periodically to pay the promised benefit to each participant upon retirement. The actuary bases the amount of plan contribution on several factors, including:

  • The retirement benefits promised by the plan
  • The age, salary, and retirement age of the participants
  • The mathematical projections (“assumptions”) of:
  • The interest to be earned by the plan assets
  • Future salary increases of the participants, and
  • The projected rates of turnover, disability, and mortality of the plan participants

You may have to purchase pension insurance

A covered defined benefit plan is subject to mandatory insurance coverage by the Pension Benefit Guaranty Corporation (PBGC). Most qualified defined benefit pension plans are covered. The PBGC is the federal agency that “insures” pensions accrued under certain defined benefit plans. This means that, if the sponsoring employer defaults on the plan, the PBGC will pay benefits to the plan participants according to the provisions of the plan (up to certain limits).

The PBGC is funded through a mandatory premium paid by employer-sponsors of covered plans. Generally, the premium is a flat annual rate per participant with a possible additional annual premium depending on the amount of the plan’s unfunded vested benefits. If you want to terminate the plan, the PBGC must be notified in advance and must approve any distribution of plan assets to participants.

The maximum annual benefit is limited to employees with at least 10 years of participation

The maximum dollar limit ($245,000 for 2022) is reduced for any participant with a retirement age earlier than 62. In addition, the maximum dollar limit is restricted to employees who have completed at least 10 years of plan participation. The maximum benefit is reduced proportionately for each year less than 10 that the employee has participated in the plan. Similarly, both the 100 percent of compensation limit and the $10,000 exception, are reduced proportionately for each year of service (as opposed to participation) less than 10.

Employees who leave well before retirement may receive relatively little benefit from the plan

If a young participant leaves a defined benefit plan, the participant will have earned only a very small benefit because of the limited length of time during which the benefit is funded. Also, the participant will not receive any benefit at all if he or she is not vested. See Questions & Answers for the required vesting schedule.

Plan benefits are not portable

An employee’s accrued retirement benefits under a defined benefit plan are not portable. In other words, when an employee terminates employment prior to normal retirement age, he or she cannot roll over accrued benefits to an IRA or another employer’s retirement plan (unless paid in a lump sum, which is atypical). For many employees, lack of portability may be perceived as a disadvantage, particularly in an age when few employees remain with the same employer for an entire career.

The plan is subject to federal “top-heavy” legal requirements

A defined benefit plan is subject to the “top-heavy” requirements of the Internal Revenue Code (IRC) that prohibit key employees from accruing significantly more benefits than non-key employees. Specifically, a defined benefit plan is top-heavy if the present value of the accrued benefits of the key employees (generally, owners and officers) is more than 60 percent of the present value of the accrued benefits of all participants. If the plan is top-heavy, a minimum retirement benefit of 2 percent of pay per year of service (but not more than 20 percent of pay) must be provided for all non-key participants, and special vesting rules apply.

The plan is not allowed to discriminate in favor of highly compensated employees

Basically, this means that your highly compensated employees (see Questions & Answers for the definition of highly compensated employee) may not benefit substantially more under the plan than your non-highly-compensated employees. To insure that this is the case, you are required to undergo annual nondiscrimination testing.

Tip: State and local government plans are exempt from discrimination testing.

If the plan is underfunded, the company must catch up

If, during the course of the plan, it appears that the plan’s current assets will not be adequate to produce the guaranteed payments under the plan, the actuary will recalculate the contributions necessary to fund the plan. The company must fund the additional contributions regardless of whether it has sufficient income. Underfunding may be caused by poor investment performance or the hiring of workers who require faster funding based on age and salary.

The plan is generally subject to reporting and disclosure rules

A traditional defined benefit plan is subject to the reporting and disclosure requirements under the Employee Retirement Income Security Act (ERISA) and the IRC.

Tip: ERISA doesn’t apply to governmental and most church retirement plans, plans maintained solely for the benefit of non-employees (for example, company directors), plans that cover only partners (and their spouses), and plans that cover only a sole proprietor (and his or her spouse).

How do you establish a defined benefit plan?

Have a plan developed for your business.

Due to the nature of the rules governing qualified defined benefit plans, you will need a retirement plan specialist and an actuary to develop a plan that meets legal requirements as well as the needs of your business. You must:

  • Determine the plan features most appropriate for your business: Carefully review your business, looking at factors such as your cash flow and profits, how much you and your employees will benefit from the plan, tax deduction needed, and employee population (tenure, ages, salaries, turnover), to determine plan features including retirement benefit, eligibility requirements, etc.

  • Choose the plan trustee (this may or may not be you): The assets of the plan must be held in trust by a trustee. The trustee has overall responsibility for managing and controlling the plan assets, preparing the trust account statements, maintaining a checking account, retaining records of contributions and distributions, filing tax reports with the IRS, and withholding appropriate taxes.

  • Choose the plan administrator: Administering the plan involves many duties, including managing the plan (determining who is eligible to participate in the plan, the amount of benefits, and when they must be paid) and complying with reporting and disclosure requirements. The plan administrator may also be responsible for investing plan assets and/or providing investment educational services to plan participants. The employer is legally permitted to handle these responsibilities in-house, but plan sponsors will frequently hire a third-party firm or financial services company to assist in performing the function of plan administration. Be sure to comply with ERISA’s bonding requirements.

Submit the plan to the IRS for approval

Once a plan has been developed, it should be submitted to the IRS if it is not a previously approved prototype plan. Since there are a number of formal requirements (for example, you must provide a formal notice to employees), a retirement plan specialist should assist you in this task. Submission of the plan to the IRS is not a legal requirement, but it is highly recommended. See Questions & Answers. The IRS will carefully review the plan and make sure that it meets all legal requirements. If the plan meets all requirements, the IRS will issue a favorable “determination letter.” If the plan does not meet all requirements, the IRS will issue an adverse determination letter indicating the deficiencies in the plan.

Adopt the plan during the year in which it is to be effective

You must officially adopt your plan during the year in which it is to become effective, so plan ahead and allow enough time to set up your plan before your company’s year-end. A corporation adopts a plan by a formal action of the corporation’s board of directors. An unincorporated business should adopt a written resolution in a form similar to a corporate resolution.

Provide a copy of the summary plan description to all eligible employees

ERISA requires you to provide a copy of the summary plan description (SPD) to all eligible employees within 120 days after your plan is adopted. A SPD is a booklet that describes the plan’s provisions and the participants’ benefits, rights, and obligations in simple language. On an ongoing basis you must provide new participants with a copy of the SPD within 90 days after they become participants. You must also provide employees (and in some cases former employees and beneficiaries) with summaries of material modifications to the plan. In most cases you can provide these documents electronically (for example, through email or via your company’s intranet site).

File the appropriate annual report with the IRS

Each employer that maintains a qualified retirement plan is generally required to file an annual report with the IRS. The annual report is commonly referred to as the Form 5500 series return/report. You must file the appropriate Form 5500 series return/report for your plan for each plan year in which the plan has assets. Consult a tax or retirement plan specialist for more information.

What are the tax considerations?

Income Tax

Your employer contributions can be deducted from income

You can deduct your employer contributions to the defined benefit plan. Employees are not taxed on the contributions you (the employer) make on their behalf until the benefits are distributed to them.

Defined benefit plan assets accrue tax deferred

Amounts in defined benefit plans, including investment earnings, are not subject to income tax until withdrawn.

Income tax is due as distributions are made

Distributions from your defined benefit plan are subject to income tax in the year they are distributed.

Early distributions may result in a premature distribution tax

If a participant takes a distribution from your defined benefit plan before reaching age 59½, the participant may be subject to a federal 10 percent premature distribution tax (unless an exception applies) and possibly a state penalty tax, too.

Minimum distributions are required after age 72

If you own more than 5 percent of the business, you must begin taking required minimum distributions from the defined benefit plan by April 1 of the year after the year you reach age 72. This applies to you if, for the plan year ending in the calendar year in which you reach age 72, you own (or are considered to own) more than 5 percent of the outstanding stock or voting power of the employer, or more than 5 percent of the capital or profits interest in the employer.

A different rule applies to your employees, as long as they don’t own more than 5 percent of the business. An employee generally must begin to receive distributions by April 1 of the first year after the later of the following years:

  • The calendar year in which he or she reaches age 72, or
  • The calendar year in which he or she retires

Caution: In some cases, however, a plan may require you to begin receiving distributions by April 1 of the year after the year you reach age 72, even if you have not retired.

Your business may qualify for the small employer pension plan start-up tax credit

If you establish a new defined benefit plan, you may be eligible to receive an income tax credit of up to $500 (50 percent of the first $1,000 of qualified start-up costs to create or maintain the plan) in three tax years. The credit may be claimed for qualified costs incurred in each of the three years starting with the tax year when the plan became effective.

Estate Tax

The value of a participant’s vested benefit is included in the decedent’s gross estate

The entire value of a participant’s vested benefit is included in a deceased participant’s gross estate for federal estate tax purposes.