Setting up a new retirement plan? Before you get started, you better make sure that you understand a few key details. The first step is comparing two unique plan structures: Defined Benefit Plan vs Defined Contribution Plan.
Simply put, a defined benefit plan establishes the benefit that is paid out in the future, while a defined contribution plan establishes the amount that can be contributed to the plan and does not address any future amount. But let’s take a look at the specifics.
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How Does a Defined Benefit Plan Compare to a Defined Contribution Plan?
The main difference is what each of the plans promise to employees. A defined benefit plan specifies how much monthly retirement income employees receive upon retirement. However, a defined contribution plan simply specifies what the employee and employer contributes to a designated employee’s retirement account.
The core of the difference between defined benefit and defined contribution plans lies in who gets affected by the plan’s rate of return. In a defined contribution plan, a participant receives whatever balance is in his account based on the rate of return in the plan.
In a defined benefit plan, the plan sponsor is taking responsibility for any fluctuations in the market. The participant must receive a fixed amount and, if the plan’s investments do not earn a rate of return to guarantee that benefit, then the sponsor must contribute enough to make up the difference.
Because of the nature of the defined benefit plan, the costs are significantly higher for older employees than younger employees. Assuming retirement at age 60, the plan sponsor has 35 years to “fund up” the benefit for a 25-year-old but only 5 years for a 55-year-old. Therefore, a defined benefit plan can offer significant advantages for an older employer with younger employees as illustrated below.
Difference Between Defined Benefit Plan and Defined Contribution Plan
A corporation has two non-key employees and two owners. The non-key employees each earn $30,000 and are ages 25 and 35 on the first day of the plan year. The owners each earn in excess of $200,000 and are ages 55 and 65.
Retirement age is defined as the later of age 60 or five years of plan participation. The contributions under a defined benefit plan as contrasted to a 20% of pay defined contribution plan are illustrated below:
The defined benefit plan offers a higher percentage to the self employed owner, and the dollar amount available for the owner is significantly higher. However, one of the disadvantages of defined benefit plans is the increased costs for older employees. If this corporation had a 45- or 55-year-old employee earning $30,000, the respective costs would be $14,895 and $38,186.
Next we look at the amounts accumulated in five years for the example above. This would be the date that the owners reach normal retirement age under the plan. For the defined contribution plan we assumed a 6% average rate of return over all years.
A defined benefit plan must meet more complex regulatory restrictions and administrative procedures. An actuary is required to certify the annual costs and calculate the annual valuation of benefits for employees. Administrative fees are generally higher due to these factors. But make sure that you get a quote from a defined benefit plan TPA.
Defined benefit plans must pay a premium and report funding levels annually to the Pension Benefit Guaranty Corporation (PBGC). The PBGC is a federal entity that insures benefits in most defined benefit plans. Generally, plans that only cover owners and plans sponsored by professional organizations that employ less than 25 individuals are exempt from PBGC coverage.
The PBGC will pay benefits to participants if the funds are insufficient to do so and the plan sponsor is unable to contribute enough to make up the difference. The PBGC then goes after the plan sponsor to pay back the difference.
Any other differences?
One of the most notable benefits is the contribution limit that comes with a cash balance plan. Having a cash balance plan can allow for a larger contribution amount, allowing people to save more as the approach retirement.
Increased benefit and compensation limits included in the Economic Growth and Tax Relief Reconciliation Act (“EGTRRA”) as well as the downturn in investment markets have refocused attention on defined benefit plans as alternatives to defined contribution plans.
Defined Benefit Plan vs Defined Contribution Plan
- Are contribution amounts limited upfront? Defined contribution plans establish contribution limits up front. What the funds earn subsequently is not relevant.
- Are you looking for a benefit in the future? If you are looking to “lock in” an amount at some point down the road then that is more characteristic of a defined benefit plan.
- Have you considered contribution levels? If you are comfortable with relatively low contributions like $10,000 to $30,000 then stick with a defined contribution plan. If your goal is $100,000 plus in contributions you will need to consider a defined benefit plan.
- What about plan costs? Because of the complexity and need for an actuary, defined benefit plans will cost substantially more. But the large contributions may justify the higher cost.
- How long do you plan on having the plan? Remember that defined benefit plans are meant to be permanent plans. But defined contribution plans are generally elective, so you can choose if you will contribute from year to year.
They can also take a lump-sum benefit, subject to their spouses’ consent, equal to their account balance, which is $100,000. The lump-sum amount can be rolled over into an Individual Retirement Account (IRA) or another employer’s cash balance plan if the employee gets employed elsewhere.
Tell me more about defined contribution plans
The most popular defined contribution plan is a 401k plan. A 401k is a retirement plan designed for self—employed people that do not employ other individuals outside of themselves and/or their spouse.
If you are the owner of a sole proprietor business, an S Corporation, C Corporation, or a partnership, a retirement plan you may want to consider is the 401k. Establishing a Solo 401k is relatively simple. There are no required discrimination tests of Form 5500 filing, which is a form bigger 401k plans must file with the IRS in order to be in compliance. Unless your 401k account reaches more than $250,000, you will not have to file the Form 5500 with the IRS.
The 401k account is mislabeled because you can actually set up an account for you and your spouse. You can also utilize the 401k in a partnership and can exclude any employee working part time with less than 1,000 hours each year.
If you have employees that work more than those hours or plan on hiring employees at some point in the future, a different plan should be considered. You do not have to contribute to your account each year but are 100% vested immediately.
Setting Up a 401k
In order to make a contribution for a tax year, a plan has to be established by the end of the business tax year. This differs from a SEP IRA which allows account set up until taxes are filed. A big benefit of the plan is that the administrative requirements are relatively minimal since the plan is only for you.
When you are making the profit-sharing contributions, the owner and their spouse must get the same percentage of pay contributions. You can make contributions at any time of the year as long as the account has been set up and the contributions have been made before December 31st.
Other Plan Details
You are allowed to borrow from a 401k plan. You are able to borrow up to either 50% of the value of the account or $50,000. You must first check to ensure the custodian of the account permits borrowing by reading the terms of the account. If borrowing is allowed, the terms of borrowing include:
- Repayment of the amount using an amortization schedule of 5 years or less.
- Regular repayments must be made at least quarterly
- The rate of interest is deemed reasonable and is typically calculated as prime rate plus 1%
Another benefits of the 401k plan is that you can manage your account without having to deal with another party including banks, brokers, or trust companies.
It is wise to consider the advantages and disadvantages of each type of retirement account before making a commitment. If you are eligible for a 401k account, read the fine print of the account and be sure it is compatible with your financial goals.
The defined benefit plan design can offer larger accumulations at retirement for some small business owners with lower costs for younger, non-key employees. However, there can be negative consequences that must be explored before such a plan is adopted.
Defined benefit plans can be a valuable tool for retirement planning. There are additional pension rules and administrative burdens that accompany these plans. A plan sponsor who is educated as to the potential pitfalls and secure in continuing the plan can accumulate substantial amounts within these plans by retirement age.