Defined-benefit pension plans are qualified retirement plans that provide fixed and pre-established benefits to plan participants when they retire. The plans are popular with employees, who enjoy the security of fixed benefits when they retire, but they have fallen out of favor with employers, who now favor defined-contribution plans in their place, as they don’t cost employers as much money.
Nevertheless, defined-benefit plans haven’t completely gone the way of the dodo. And as they can be complex, it’s important to understand the rules mandated by the Internal Revenue Service (IRS) and the federal tax code.
Key Takeaways
- Defined-benefit pension plans are funded by an employer from a company’s profits and generally do not require employee contributions.
- The amount of each individual's benefits is usually linked to their salary, age, and length of employment with a company.
- To be eligible for benefits, an employee must have worked a set amount of time for the company offering the plan.
- In most cases, an employee receives a fixed benefit every month until death, when the payments either stop or are assigned in a reduced amount to the employee’s spouse, depending on the plan.
How a Defined-Benefit Pension Plan Works
A defined-benefit pension plan requires an employer to make annual contributions to an employee’s retirement account. Plan administrators hire an actuary to calculate the future benefits that the plan must pay an employee and the amount that the employer must contribute to provide those benefits. The future benefits generally correspond to how long an employee has worked for the company and the employee’s salary and age.
Generally, only the employer contributes to the plan, but some plans may require an employee contribution as well. To receive benefits from the plan, an employee usually must remain with the company for a certain number of years. This required period of employment is known as the vesting period.
Employees who leave a company before the end of the vesting period may receive only a portion of the benefits. Once the employee reaches the retirement age, which is defined in the plan, they usually receive a life annuity. Generally, the account holder receives a payment every month until they die.
Companies cannot retroactively decrease benefit amounts for defined-benefit pension plans, but that doesn't mean these plans are protected from failing.
Examples of Defined-Benefit Pension Plans
One type of defined-benefit plan might pay a monthly income equal to 25% of the average monthly compensation that an employee earned during their tenure with the company. Under this plan, an employee who made an average of $60,000 annually would receive $15,000 in annual benefits, or $1,250 every month, beginning at the age of retirement (defined by the plan) and ending when that individual died.
Another type of plan may calculate the benefits based on an employee’s service with the company. In this scenario, a worker may receive $100 a month for each year of service with the company. Someone who worked for 25 years would receive $2,500 a month at their retirement age.
Variations on Benefit Payments
Each plan has its own rules on how employees receive benefits. In a straight life annuity, for example, an employee receives fixed monthly benefits beginning at retirement and ending when they die. The survivors receive no further payments. In a qualified joint and survivor annuity, an employee receives fixed monthly payments until they die, at which point the surviving spouse continues to receive benefits equal to at least 50% of the employee’s benefits until the spouse dies.
Some plans offer a lump-sum payment, where an employee receives the entire value of the plan at the time of retirement, and no further payments are made to the employee or survivors. Whatever form the benefits take, employees, pay taxes on them, while the employer gets a tax break for making contributions to the plan.
Defined-Benefit vs. Defined-Contribution Plans
In a defined-contribution plan, employees fund the plan with their own money and assume the risks of investing. Defined-benefit plans, on the other hand, don’t depend on investment returns. Employees know how much they can expect at retirement. The federal government does not insuredefined-contribution plans, according to the Pension Benefit Guaranty Corporation (PBGC), but it currently does insure a percentage of defined-benefit plans.
Federal Tax Requirements
The IRS has created rules and requirements for employers to establish defined-benefit plans. A company of any size can set up a plan, but it must file Form 5500 with a Schedule B annually. Furthermore, a company must hire an enrolled actuary to determine its plan’s funding levels and sign Schedule B.
In addition, companies cannot retroactively decrease benefits. Businesses that do not either make the minimum contributions to their plans or make excess contributions must pay federal excise taxes. The IRS also notes that defined-benefit plans generally may not make in-service distributions to participants before age 62, but such plans may loan money to participants.
As an expert in retirement planning and pension systems, I have an in-depth understanding of the intricacies surrounding defined-benefit pension plans. My expertise is grounded in practical knowledge and a comprehensive grasp of the relevant regulations, particularly those mandated by the Internal Revenue Service (IRS) and the federal tax code.
Defined-Benefit Pension Plans: An Overview
Defined-benefit pension plans are qualified retirement plans that offer fixed and pre-established benefits to participants upon retirement. These plans are funded by employers, typically from company profits, and do not usually require employee contributions. The appeal for employees lies in the security of receiving fixed benefits post-retirement. However, they have fallen out of favor with employers who prefer defined-contribution plans due to lower costs.
Key Concepts and Features:
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Funding and Contributions:
- Employers make annual contributions to employees' retirement accounts.
- Plan administrators enlist actuaries to calculate future benefits based on factors like salary, age, and length of employment.
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Eligibility and Vesting:
- Employees become eligible for benefits after working a set period for the company.
- Vesting period: The duration an employee must remain with the company to receive full benefits.
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Benefit Structure:
- Benefits linked to salary, age, and employment duration.
- Usually, only the employer contributes, but some plans may involve employee contributions.
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Retirement Age and Annuities:
- Employees typically receive a fixed benefit monthly until death, with payments possibly continuing to a spouse.
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Protection and Limitations:
- Benefit amounts cannot be retroactively decreased, but defined-benefit plans are not immune to failure.
Examples of Defined-Benefit Plans:
- Monthly income based on a percentage of average compensation.
- Benefits calculated according to years of service.
Variations in Benefit Payments:
- Straight life annuity: Fixed monthly benefits until death.
- Qualified joint and survivor annuity: Payments continue to the spouse after the employee's death.
Tax Implications:
- Employees pay taxes on benefits, and employers receive tax breaks for contributions.
Defined-Benefit vs. Defined-Contribution Plans:
- Defined-contribution plans involve employee-funded accounts with investment risks.
- Defined-benefit plans provide fixed benefits and are not dependent on investment returns.
Federal Tax Requirements:
- IRS rules mandate the establishment of defined-benefit plans by employers.
- Filing Form 5500 with Schedule B annually is required.
- An enrolled actuary determines funding levels and signs Schedule B.
- Retroactive benefit decreases are prohibited.
- Non-compliance with contributions results in federal excise taxes.
- Defined-benefit plans may not make in-service distributions before age 62, but loans to participants are allowed.
In summary, understanding the complexities of defined-benefit pension plans is crucial, considering both employer and employee perspectives and navigating the regulatory landscape outlined by the IRS and federal tax code.
