Defined Benefit Plans are a traditional pension plan that offers excellent tax and retirement savings for small businesses.
This Plan promises a specific monthly benefit at retirement. The Plan may state this promised benefit as an exact dollar amount, such as $100 per month at retirement. Or, more commonly, it may calculate a benefit through a plan formula that considers such factors as salary and service —for example, five percent of average salary for the last five years of employment for every year of service with an employer.
The employer is responsible for making annual contributions that are sufficient for funding the promised benefit. The contributions are required annually and are calculated by an actuary using minimum funding standards designed to ensure that the value of benefits accumulated and the plan’s assets bear a reasonable relationship to one another. Contributions are made to a Defined Benefit Trust that is invested on behalf of all plan participants. For a traditional Defined Benefit Plan with employees, a six-year graded vesting schedule is typically used.
Traditional Defined Benefit Plans are complex and very difficult to understand. Unlike a traditional Defined Benefit Plan, a CASH BALANCE PLAN is a Defined Benefit Plan that defines the promised benefit in terms of a stated account balance similar to a Profit Sharing Plan.
In a typical Cash Balance Plan, a participant’s account is credited each year with a ‘pay credit’ (such as five percent of compensation from his/her employer) and an ‘interest credit’ (either a fixed rate or a variable rate that is linked to an index as the one-year treasury bill rate). Unlike a traditional Defined Benefit Plan, increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. Thus, the investment risks and rewards on plan assets are borne solely by the employer as the Fiduciary investing the Trust assets. When a participant becomes entitled to receive benefits under a Cash Balance Plan, the benefits that are received are defined in terms of an account balance similar to a Profit Sharing Plan.
The benefits in most Cash Balance Plans, as in most traditional Defined Benefit Plans, are protected within certain limitations, by federal insurance provided through the PBGC. Certain plans, as an example, one owner (and spouse) plans are exempt from PBGC coverage.
New in 2010, DB4k PLANS are considered ‘hybrids’ combining a Traditional Defined Benefit Plan with a 401(k) feature. The Defined Benefit contributions must vest 100% in three years. The 401(k) component automatically enrolls participants to contribute 4% of their wages UNLESS they opt out or opt for a lesser percentage to be contributed. For each participant participating in the 401(k), however, the employer must contribute a 100% vested matching contribution of 50 cents on the dollar up to 4% of wages.