Defined Benefit Plans
Traditional Defined Benefit Plans
Commonly referred to as a pension, a defined benefit plan pays benefits from a trust fund using a specific formula set forth in the plan document, based on salary, age and years of service. In contrast to a Defined Contribution Plan in which benefits are limited to amounts contributed to an individual account, a Defined Benefit Plan defines a retirement benefit that will be paid upon retirement – irrespective of amounts previously contributed to the plan. The statutory definition of Defined Benefit Plan encompasses all pension plans that do not meet the IRC Section 414 definition of a Defined Contribution Plan.
Defined Benefit Plan Features
- Substantial benefits can be provided and accrued within a short time – even with early retirement
- Employers can contribute – and deduct for tax purposes – more than under other retirement plans
- Plan provides a predictable benefit to retirees
- Vesting can follow a variety of schedules from immediate to spread out over seven years
- Most administratively complex plan
- An excise tax applies if the minimum contribution requirement is not satisfied
- An excise tax applies if excess contributions are made to the plan
- Can be combined with other Qualified Plans, such as a 401(k), for maximum flexibility and deductions
Defined Benefit Plan Contributions
The employer makes most contributions. Sometimes, employee contributions are required or voluntary contributions may be permitted.
Defined Benefit Plan Contribution and Benefit Limits
Tax-deductible contributions are limited to the amount required to maintain the plan’s funded status.
Contributions to a Defined Benefit Plan are based on what is needed to provide definitely determinable benefits to plan participants. Actuarial assumptions and computations are required to figure these contributions.
For 2017, the annual benefit to be provided to a participant under a defined benefit plan can’t exceed the lesser of the following amounts.
- 100% of the participant’s average compensation for his or her highest 3 consecutive calendar years.
- $215,000 ($210,000 for 2016).
Defined Benefit Plan Eligibility Requirements
An employee must be allowed to participate in your plan if he or she meets both the following requirements.
- Has reached age 21.
- Has at least:
- 1 year of service
- 2 year of service, if the plan provides that after not more than 2 years of service the employee has a nonforfeitable right to all his or her accrued benefit and the plan is not a 401k Plan
Defined Benefit Plan Minimum Coverage Requirement
To be a qualified plan, a defined benefit plan must benefit at least the lesser of the following.
- 50 employees, or
- The greater of:
- 40% of all employees, or
- 2 employees.
If there is only one employee, the plan must benefit that employee.
Defined Benefit Contributions or benefits must not discriminate. Under the plan, contributions or benefits to be provided must not discriminate in favor of Highly Compensated Employees.
Cash Balance Plans
Hybrid plan designs combine the features of defined benefit and defined contribution plans. In general, they are treated as defined benefit plans for tax, accounting, and regulatory purposes. As with defined benefit plans, investment risk is largely borne by the plan sponsor. A typical hybrid design is the Cash Balance Plan, in which employees have notional accounts whose balances are a factor of (A) employer contributions and (B) a defined rate of interest.
The employer contribution is based on a formula incorporated into the plan document and can be a percentage of pay, a flat dollar amount, or a combination of those.
The annual interest credit to a participant’s notional account is not dependent on investment performance, but rather is guaranteed by the plan.
Upon termination of plan participation, the balance of the notional account can be distributed as a lump sum, an annuity, or rolled over to an IRA.