We know it is tough to understand how a defined benefit retirement plan works. In this guide, we will show you how they work and point out a few tips along the way.
In a defined contribution plan, the benefit upon termination of employment is the vested percent of the participant’s account balance. The vested percent increases with service, generally reaching 100% by the seventh year.
In a defined benefit pension plan, the account balance is replaced by the concept of an accrued benefit. A participant accrues (or earns) a portion of his projected benefit at retirement each year that he is in the plan.
A joint and survivor annuity pays a monthly amount during the life of the participant and a reduced amount (usually 50%) upon the participant’s death for the remaining life of the spouse. Both the spouse and the participant must consent in writing to waive this form of benefit calculation if the participant wants to take a lump sum or other form of an annuity.
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Tax Deductions Available for a Defined Benefit Pension Plan
The private sector enjoys better tax treatment than the public sector because the employer funds most pension plans in the private sector and employees in the public sector.
For a plan to qualify for tax deductions, it must meet the minimum standards set on participation, vesting, and non-discrimination against low-paid employees. These requirements help regulate pension plans. Going against the requirements means the employer’s contribution will be considered a taxable income on the employee to be tax-deductible for the employer.
This article will discuss how contributions, investment income, and benefit payments are treated when it comes to taxation in a defined benefit pension plan.
Defined Benefit Retirement Plan Contributions
Corporate income tax allows employer contributions and wages to be deducted from business expenses. Employer contributions are also not taxed as income to the employees under personal income and Social Security payroll taxation.
But employee contributions are generally taxable for personal income taxation and Social Security payroll tax; contributions by an employee to salary reduction plans are not taxed.
However, limits are set for defined benefit plan contributions to protect the Treasury against excessive tax deductions. Limits are calculated on maximum employee earnings used to determine contributions or benefits.
Investment Returns
Once employers and employees have contributed to a defined benefit plan, they invest assets to grow their funds; earnings from these investments are not taxed. Assets maintained by the plan are also not taxable.
However, in the event of a termination of the defined benefit plan and the employer gains on surplus plan assets, the surplus is subjected to a corporate tax income plus an excise tax at 20%. It may rise to 50% if the employer does not transfer the excess assets to the replacement plan or increase the plan benefits to the participants. Excise tax helps discourage employers from misusing plans and discourage firms from terminating defined benefit plans.
Distribution of Benefits
Benefits from a defined benefit plan are received at retirement or earlier and are subject to federal and state personal income taxation. However, they are exempted from the Social Security payroll tax.
A participant also recovers the amounts that have previously been taxed. Progressivity of the income tax system allows a participant to pay lower taxation in retirement than when continuously taxed on income when working. An excise tax is also incurred when one takes lump-sum benefits before retirement. Excise tax discourages early distribution as pension plans are designed to generate retirement income.
Terminating a plan?
In many situations, business owners are so eager to fund a plan that they don’t realize the permanency of the plans. Defined benefit plans are not elective. So you cannot start and stop the plan as you see fit.
Companies are often hesitant to adopt plans because they are more expensive and complex to understand. Plus, they do require the company to commit to annual funding requirements. This can scare away even the most cash-rich companies. But the tax savings will often outweigh any other downsides.
The IRS assumes the plans are permanent and can only be changed or terminated based on particular situations. The main hurdle to closing a plan is demonstrating “business necessity.” The owner cannot simply say that they wish to terminate the plan for no apparent reason. This typically will not go over well with the IRS.
A valid reason would be an unforeseen reduction in profits, a change in ownership structure, or a significant difference in cash flows. On occasion, the IRS has allowed termination due to adopting different retirement plans. A company may be able to demonstrate that a different plan is more suitable for the business.
The IRS also states that a plan should be for a “few years.” But what does this mean, and how is it defined? The IRS will not question a termination that occurs at least ten years after the original plan adoption. Companies that terminate plans in the 5-10 year range have not faced much pushback from the IRS.
How does the calculation work?
Furthermore, the calculation is repeated each year, considering the plan’s past investment experience, assumptions about future participant compensation increases, and assumptions about the plan’s future investment performance.
Contributions to defined benefit plans are required each year and may change yearly. Except for changes in the covered participants, the contribution changes are based principally on how well or how poorly plan assets perform and whether or not the performance meets the growth assumptions underlying the annual actuarial calculation.
The employer assumes the investment risk in a defined benefit plan, and the employer1 generally makes all contributions. The employer is charged with the responsibility to fund the plan adequately, despite the plan’s investment experience.
If the investment returns are good, the required employer contributions will tend to decline. If investment returns are poor, then contributions will increase.
Employers must make the required contributions to adequately fund the required benefit, regardless of the participant’s age at plan entry. A defined benefit plan’s contributions are disproportionately higher for older employees than younger employees.
Because older entrants to the plan normally have fewer years of plan participation before they retire, a larger portion of annual contributions goes towards providing benefits for them. Although younger employees will receive their promised benefit, they are not favored in terms of a defined benefit plan’s allocation of contributions.
Benefit calculation
Benefits under defined benefit plans are often, although not always, stated in terms of a percentage of the participant’s final compensation. In such a case, the higher the level of the participant’s compensation, the greater the plan contribution must be to fund the participant’s retirement income. To illustrate, assume that two employees, age 45, participate in a defined benefit plan promising to pay a retirement income of 60% of their final compensation.
Employee A earns $50,000 annually, and employee B earns $100,000 annually. Without considering their likely compensation growth, if each of these two employees continued to earn the same income until retirement, employee A could look forward to receiving a monthly retirement income of $2,500. ($50,000 X 60% = $30,000 ÷ 12 months = $2,500).
Employee B could expect to receive a monthly retirement income of $5,000 each month. The employer would need to make substantially higher contributions—perhaps double the amount—to fund employee B’s benefit.
Conclusion
A defined benefit pension plan becomes attractive when an employer or employee receives a tax benefit for deferring compensations. Tax deductions should be enjoyed by both the employer and the employee to encourage plan preference.
Constraints to overfunding and an early lump-sum withdrawal should be eliminated to increase the tax advantages under defined benefit plans.
