How Does a Defined Benefit Plan Work?

9th Nov 2020

Screenshot of Forbes article What Is A Defined Benefit plan

When people hear the term Defined Benefit plan, many assume it’s a retirement or pension plan for a large company. It’s not common knowledge that small businesses with 1-10 employees also can reap the tax and retirement benefits of Defined Benefit plans. Many also aren’t aware of the tax advantages of Defined Benefit plans. The article What Is a Defined Benefit Plan on shares the nuts and bolts of Defined Benefit plans.

The Essence of a Defined Benefit Plan

A Defined Benefit plan, more commonly known as a pension plan, is a retirement plan funded by employers, with fixed income payments based on factors that include an employee’s salary, age and tenure with the company. According to Forbes, a company might offer a plan that pays 1.5% of an employee’s average salary for the last five years of employment for every year worked at the company. If 20 years were spent working for that company, payment may be 30% of your average salary.  If you’re interested in seeing what your payout could be, run a free calculation.

Defined Benefit plans offer guaranteed retirement benefits for employees. Defined Benefit plans are largely funded by employers, with retirement payouts based on a fixed formula that considers an employee’s salary, age and tenure with the company.

How a Defined Benefit Plan Works

A Defined Benefit plan is a qualified employer-sponsored retirement plan that is eligible to receive certain tax benefits under the law, like tax-deferred investment growth or tax deductions for contributions. Most people employed at large companies are more familiar with qualified employer-sponsored retirement plans such as a 401(k). Unlike 401(k)s, Defined Benefit plans are usually funded entirely by employer contributions, although in some cases employees may be required to make some contributions.

Cash Balance Plans

A Cash Balance plan is a Defined Benefit plan that gives employees a fixed amount of money at the time of retirement or when they leave the company instead of a monthly payout. Cash Balance plans are often seen as a hybrid between traditional pensions and 401(k)s. While employers still take on all of the investment risk associated with managing retirement funds, they do not guarantee indefinite benefit payments. Instead, participants are guaranteed up to a certain amount of funds.

Cash balance plans generally calculate benefits based on your total working years with a company, not just your last or highest earning period, meaning some people end up with fewer benefits, if their companies switch to a Cash Balance plan from a pension plan, according to Forbes.

Advantages of Defined Benefit Plans

  • Payments are not affected by market fluctuations. No matter what the investments are, the employee retirement benefit remains the same
  • High contributions to a qualified retirement plan may be $100,000 or more and as much as 100% of an employee’s income
  • Employers get a full tax deduction for contributions to Defined Benefit plans
  • Investments grow tax-deferred which helps to build wealth faster than a taxable investment

If you’re interested in learning more about the essentials of Defined Benefit plans, read the full article.

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