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Defined Benefit Plan
What’s the difference between a defined benefit plan and a defined contribution plan?
A defined-benefit plan guarantees a specific benefit or payout upon retirement. The contributions needed to meet this specified amount at retirement are tax deductible and can allow business owners to make large, tax deductible contributions into their own plans during their high income years. As individuals plan for retirement, it’s important to understand the difference between these two benefit plan types.
A defined-benefit plan guarantees a specific benefit or payout upon retirement, the benefit may be a set amount or may be calculated according to a formula that factors in years of service, age and average salary. The employer typically funds the plan in a tax-deferred account by contributing a regular amount to the plan.
A defined contribution plan sets the limits both employees and employers are permitted to contribute funds into a defined contribution plan. Employer contributions are usually formula based. For example, the level of the employer’s contributions might be a function of the employee’s salary, their age, and years of service with the company. A new employee, that is also relatively young, might receive an annual employer contribution equal to 2% of their salary. An older employee, with 30 plus years of service, might receive a contribution closer to 12% of their salary.
To summarize the difference between defined contribution and benefit plans:
- Employees and employers can provide funding to defined contribution plans. While the employer contributions are formula-driven and guaranteed, retirement income will depend on the performance of the fund’s investments.
- Employers are responsible for supplying all funding to defined benefit plans. The employee’s retirement income is both formula-driven and guaranteed.
Obviously, a defined benefit plan can be a much better deal for a business owner in their high income years, as these plans differ from regular defined contribution plans, (401k’s, SIMPLES, SEP’s, and other hybrid qualified retirement plans) in that the tax deductible contributions are determined by the actuarially calculated value desired at retirement, rather than setting the maximum limit one can contribute and deduct per year.
You can establish a defined benefit plan if you:
- Are a business of any size
- Have an enrolled actuary determine the funding levels
Pros and cons
- Substantial benefits can be provided and accrued within a short time; even with early retirement
- Employers can contribute (and deduct) more than under other retirement plans
- Plan provides a predictable benefit
- Vesting can follow a variety of schedules from immediate to spread out over seven years
- Benefits are not dependent on asset returns
- Plan can be used to promote certain business strategies by offering subsidized early retirement benefits
- More 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