Defined Benefit Plan: Everything You Need to Know
Defined benefit plans can be a great source of retirement income. 3 min read
Defined Benefit Plan
A defined benefit plan, also referred to as a pension plan, is a retirement plan, which is calculated using a formula that considers length of employment and income history. It is termed ‘defined’ due to the fat that the formula is defined ahead of time. Such defined benefit plan ensures a specific payout once you retire.
Such plans are qualified employer-sponsored retirement plans that offer tax benefits to those employers and employees participating in the plan. Therefore, the employer can deduct contributions made to the plan while the employee won’t owe tax on the contributions made to the plan.
However, there are specific rules that must be adhered to, which are set forth in the vesting requirements.
How Will Retirement Benefits Be Paid
Benefits can be paid in a single life annuity, a qualified joint and survivor annuity, or via a lump sum paid to the employee upon retirement.
Single life annuity. The employee may receive a fixed monthly benefit until he dies, at which point the payments will cease.
Qualified joint and survivor annuity. Some companies may provide for continued payments to the spouse of the deceased employee, in either full amounts or in amounts equal to 50% of the full amount, until the spouse dies.
Lump-sum payment. Some companies provide a lump-sum payment to the employee upon retirement; however, if the employee is deceased, the lump sum will be given to the spouse of the deceased.
Difference Between Defined Benefit Plan and Contribution Plan
A contribution plan, also referred to as a 401(k), is less expensive than a defined benefit plan. Moreover, a benefit plan won’t usually provide the employee with enough funds to live comfortably upon retirement. If employers offer both types of plans, employees should participate in a defined contribution plan. The significant difference between both plans is that the defined benefit plan is a retirement account in which the employer provides a set payout whereas the contribution plan provides that both the employer and employee will input money into the account.
Difference Between Traditional Pension and Cash-Balance Plan
These are two categories of defined-benefit plans. In both instances, the employee is automatically enrolled and collects upon retirement. However, the employee generally must stay with the company for a period of five years before the pension vests. The significant difference between the two is how the benefits are calculated. In a pension, the formula takes into account the length of time on the job and average salary during the last couple years of employment. The cash-balance plan credits the account with a set percentage of one’s salary each year. Another difference is in regard to the employee leaving the company before he or she hits retirement age. If the employee leaves, he may take the compensation from the cash-balance plan in either a lump sum amount or roll it into an IRA. However, if he holds a traditional pension, the funds cannot be rolled into an IRA.
If you need help determining whether or not to participate in a defined benefit plan or need additional help determining your rights regarding your pension, you can post your legal need on UpCounsel’s marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Stripe, and Twilio.