With Defined Benefit Plans, employees’ payments are calculated according to how long they have been with the company, and what their salary level was when they retired.
Defined contribution plans specify the amount that goes into a retirement plan today. This is usually a percentage of the employee’s salary or can be set at a specific amount. Those funds are invested, typically in mutual funds available inside the retirement plan. The amount employees receive at retirement depends on how much the employer has contributed to the plan, how much the employee has saved in the plan, how long the funds have been invested, and how well the investments perform in the plan.
Defined Benefit Plans Make Sense for the Small Business Owner
With a 401K, most small business owners can only defer tax payments up to around $63,500* (assuming over age 50). With a pension plan complementing other retirement vehicles, business owners can save over $200,000 for retirement, and pay taxes when the funds are distributed. Since this is typically after retirement, when their level of taxable income is lower, they potentially save even more.
Pension Plans Sweeten your Employee Benefits Package, Increasing Employee Retention
When you offer all of your employees a pension plan as part of their benefits package, you can increase worker retention as well as have a better chance of attracting the best talent to your business. Offering a pension plan makes your company more competitive in the realm of recruitment. Plans can be funded through profit-sharing as well, which gives employees more incentive to perform at top productivity levels. By offering plans on a gradual vesting basis, you can also help to build a more dedicated long-term workforce for your business.
Cash Balance Pension Plans
A Cash Balance Plan is a Defined Benefit Plan that looks like a defined contribution plan. Similar to such plans, fixed contributions are credited to each participant at the end of each year.
In addition, participants receive interest credits based on the interest rate defined in the plan. The credit is a fixed rate specified in the plan. Increases or decreases in the value of the plan’s investments do not directly affect the benefits promised to the participants. The investment risks and rewards are borne solely by the employer. The plan maintains a hypothetical account balance for each participant.
When the participant retires, their benefit is the value of the hypothetical account. This lump sum value can be converted to a monthly pension at retirement.
A Cash Balance plan is a Hybrid Plan. It appears to participants as a defined Contribution plan but is treated under the Internal Revenue Code as a Defined Benefit Plan. Participant statements look like a defined contribution Statement.
Cash Balance plans can help cut tax bills, which is often attractive to the older business owner looking to bump their retirement savings up. Contribution limits in Cash Balance plans are generous and increase with age. Whereas 401(k) plans for participants 50 and older are limited to $63,500*, a business owner may potentially contribute over $200,000 annually.
*Based on 2020 limits