What Is a Defined-Benefit Plan?
A defined-benefit plan is an employer-sponsored retirement planwhere employee benefits are computed using a formula that considers several factors, such as length of employment and salary history. The company is responsible for managing the plan's investments and risk and will usually hire an outside investment manager to do this.
Typically an employee cannot just withdraw funds as with a 401(k) plan. Rather, they become eligible to take their benefit as a lifetime annuity or in some cases as a lump sum at an age defined by the plan's rules.
Understanding Defined-Benefit Plan
Also known as pension plans or qualified-benefit plans, this type of plan is called "defined benefit" becauseemployees and employers knowthe formula for calculating retirement benefits ahead of time, and they use it to define and set the benefit paid out. This fund is different from other retirement funds, like retirement savings accounts, where the payout amounts dependon investment returns.
Poor investmentreturns or faulty assumptions and calculations can result in a funding shortfall, where employers are legally obligated to make up the difference with a cash contribution.
Key Takeaways
- A defined-benefit plan is an employer-based program that pays benefits based on factors such as length of employment and salary history.
- Pensions are defined-benefit plans.
- In contrast to defined-contribution plans, the employer, not the employee, is responsible for all of the planning and investment risk of a defined-benefit plan.
- Benefits can be distributed as fixed-monthly payments like an annuity or in one lump-sum payment.
- The surviving spouse is often entitled to the benefits if the employee passes away.
Since the employer is responsible for making investment decisions and managing the plan's investments, the employer assumes all the investment and planning risks.
Examples of Defined-Benefit Plan Payouts
A defined-benefit plan guarantees a specific benefit or payout upon retirement. The employer may opt for a fixed benefitorone calculated according to a formula that factors in years of service, age, and average salary. The employer typically funds the plan by contributing a regular amount,usually a percentage of the employee's pay, into a tax-deferredaccount. However, depending on the plan, employees may also make contributions. The employer contribution is, in effect, deferred compensation.
Upon retirement, the plan may pay monthly payments throughout the employee’s lifetime or as alump-sum payment. For example, a plan for a retiree with 30 years of service at retirement may state the benefit as an exact dollar amount, such as $150 per month per year of the employee's service. This plan wouldpay the employee $4,500 per month in retirement.If the employee dies, some plans distribute any remaining benefits to the employee's beneficiaries.
Annuity vs. Lump-Sum Payments
Payment options commonly include a single-life annuity, which provides a fixed monthly benefit until death; a qualified joint and survivor annuity,which offers a fixed monthly benefit until death and allows the surviving spouse to continuereceiving benefits thereafter; or a lump-sum payment, which pays the entire value of the plan in a single payment.
Selecting the right payment option is importantbecause it can affect the benefit amount the employee receives. It is best to discuss benefit options with a financial advisor.
Working an additional year increases the employee's benefits, as itincreases the years of service used in the benefit formula. This extra year may alsoincrease the final salary the employer uses to calculate the benefit. In addition, there may be a stipulation that says working past the plan's normal retirement age automatically increases an employee's benefits.
FAQs
A defined benefit plan promises a specified monthly benefit at retirement. The plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement.
How is a defined benefit plan paid out? ›
Pensions are defined-benefit plans. In contrast to defined-contribution plans, the employer, not the employee, is responsible for all of the planning and investment risk of a defined-benefit plan. Benefits can be distributed as fixed-monthly payments like an annuity or in one lump-sum payment.
What is the process of funding in a defined benefit plan? ›
The process of funding in a defined benefit plan refers to making periodic contributions to a funding agency to ensure that funds are available to meet retirees' claims. Also known as a conventional pension plan, the defined benefit plan guarantees a fixed payment upon an employee's retirement.
What is the maximum payout for a defined benefit plan? ›
In general, the annual benefit for a participant under a defined benefit plan cannot exceed the lesser of: 100% of the participant's average compensation for his or her highest 3 consecutive calendar years, or. $275,000 for 2024 ($265,000 for 2023; $245,000 for 2022; $230,000 for 2021 and 2020; $225,000 for 2019)
Are payments from a defined benefit plan taxable? ›
When must I start withdrawing benefits from the plan? Owners are required to start taking benefits at RMD age. These annual payments are taxable as income and may not be rolled over to an IRA.
Can you cash out a defined benefit plan? ›
Defined Benefit Plan Distributions
In general, benefits are not paid until the Plan's specified retirement age. This often is age 62 or 65. However, many small Plans allow the participant to "cash out" their benefit, regardless of age, by electing a lump sum distribution in lieu of annual lifetime payments.
Can you withdraw money from a defined benefit plan? ›
What are the rules for making withdrawals from a Personal Defined Benefit Plan? Penalty-free distributions may be received upon retirement or termination of service. Required Minimum Distribution (RMD) withdrawals must begin by age 73, even if you are still working.
Do employees pay into a defined benefit plan? ›
Generally, the employer makes most contributions. Sometimes, employee contributions are required, or voluntary contributions may be permitted.
How does defined benefit plan work? ›
A defined benefit plan, more commonly known as a pension, offers guaranteed retirement benefits for employees. Defined benefit plans are largely funded by employers, with retirement payouts based on a set formula that considers an employee's salary, age and tenure with the company.
What is a defined benefit plan for dummies? ›
A defined benefit plan guarantees you a certain benefit when you retire. How much you receive generally depends on factors such as your salary, age, and years of service with the company.
You have no say in how the money is invested. Moreover, you can't choose to invest more in the plan. If you want to save more for retirement, you will need to do it elsewhere, such as through an IRA or a 401(k) - if you have one.
Can you take a lump-sum from defined benefit? ›
Taking your defined benefit pension as a lump sum
You might be able to take your whole pension as a cash lump sum. If you do this, up to 25% of it will be tax-free, and you'll have to pay Income Tax on the rest.
What is the 50 40 rule for defined benefit plans? ›
In general, each defined benefit plan must cover at least the smaller of 50 participants, or 40% of the non- excludable employees, which is 24 participants. So, at least 24 participants must be covered in each plan.
How much money can a 72 year old make without paying taxes? ›
If you are at least 65, unmarried, and receive $15,700 or more in nonexempt income in addition to your Social Security benefits, you typically need to file a federal income tax return (tax year 2023).
When can you withdraw from defined benefit plan? ›
Defined benefit and money purchase pension plans
Early or phased retirement -- the plan may permit earlier distributions when you: turn age 59 1/2 (even if still employed); or. terminate employment (by death, disability, early retirement or other severance from employment).
At what age is Social Security no longer taxed? ›
Social Security income can be taxable no matter how old you are. It all depends on whether your total combined income exceeds a certain level set for your filing status. You may have heard that Social Security income is not taxed after age 70; this is false.
Does the employer pay defined benefit plan? ›
Generally, the employer makes most contributions. Sometimes, employee contributions are required, or voluntary contributions may be permitted.
Can you take a lump sum from defined benefit? ›
Taking your defined benefit pension as a lump sum
You might be able to take your whole pension as a cash lump sum. If you do this, up to 25% of it will be tax-free, and you'll have to pay Income Tax on the rest.
Is a defined benefit a lump sum or pension? ›
With a lump sum, there is no guarantee the money will last a lifetime. A regular pension payment will last until you die.
Can I cash in all of my defined benefit pension? ›
Taking your defined benefit pension as a lump sum
This is sometimes called 'trivial commutation' or taking a 'trivial lump sum'. You might be able to take the whole of your pension as a one-off lump sum if: you're at least at least 55 or retiring earlier because of ill-health.
