You may already be aware of defined contribution plans like the 401k, IRA, and solo 401k. Defined contribution plans have their contribution limits defined each year. The IRS states the maximum amount you can put in and once you reach the limits, you cannot contribute anything else.
Defined benefit plans (also known as pension plans or qualified benefit plans) promise a specified monthly benefit at retirement. Employee benefits are calculated using a formula that considers their length of employment and compensation levels. When they retire, the company will pay them an annuity paid out monthly for the rest of their lives. Some defined benefit plans, like the cash balance plan, also give employees the option to take the payment as a lump sum.
Types of defined benefit plans
There are two main types of defined benefit plans: Pensions and cash balance plans.
While pension plans have mostly been replaced by the 401k, cash balance plans, or a 401k + cash balance plan combo, are popular retirement plan structures for business owners with high W-2 income looking to make pre-tax contributions above $100,000 per year.
Pensions guarantee a monthly payment for the rest of an employee’s life, beginning at retirement. It calculates how much they’ll receive by considering the length of employment at the company and how much money they earned. Unlike a 401k, employees do not make contributions to their pension plans; it is fully funded by the employer.
Cash balance plans
Today, the cash balance plan is the more popular type of defined benefit plan. It’s often considered a hybrid between a 401k plan and traditional pension. Like a pension plan, the amount of money a participant will receive in retirement is pre-determined. However, while participants have the option to take the payments as annuities (like a pension), they can also choose to take it as a lump sum (like a 401k) and even choose to roll it over tax-free to an IRA or 401k.
The main reason that cash balance plans are popular is that they allow business owner to contribute higher amounts than what defined contribution plans like the 401k or IRA allow.
- The contribution limit of a 401k is $66,000 for 2023 if you’re under 50 years of age and $73,500 if you’re 50 years of age or older.
- The contribution limit of an IRA is $6,500 for 2023 if you’re under 50 years of age and $7,500 if you’re 50 years of age or older.
The cash balance plan has no fixed contribution limit. Instead, there is a cap on how much money the plan can hold in value at retirement. For 2023, the limit is $3.4 million. If your plan is designed to hit the $3.4 million limit in value by retirement, you would calculate your contribution limits based on how many years you have left to reach that target amount. The higher your age and compensation, the more you can contribute since you have a shorter time frame to reach the target.
While contribution limits are different for every individual, the typical contributions to a cash balance plan are between $100,000 to $300,000 annually. Contributions to a cash balance plan are made with pre-tax income and reduce your taxable income.
Defined benefit plan vs defined contribution plan
Defined contribution plan
In a defined contribution plan, like a 401k, every participant has their own accounts and can make their own investments. The account is primarily funded with employee contributions, with some companies offering employer matching as an incentive (usually in the amount of 3% to 5% of an employee’s compensation). Participants in the plan invest their own accounts and rely on positive performance of these investments to grow their balance by the eligible withdrawal age of 59½.
Defined benefit plan
In a defined benefit plan, all contributions are made by the employer. In most cases, there is no option for employees to contribute to their pension or cash balance plan. Instead of the balance determined by investments made in their accounts, the amount of money they’ll receive is pre-determined. The employer promises the employee X amount in their accounts by retirement, and is funded through a pay credit (a percentage of their compensation) and an interest credit (a fixed rate or a variable rate linked to an index).
Rather than every participant investing their own accounts, the assets are invested in a pooled trust. Whether the investments go up or down, the employee will still receive the promised interest credit (usually 5% per year).
Pros of defined benefit plans
Dependable income for participants
In a defined benefit plan, participants are guaranteed benefits at retirement. With a pension, you receive a monthly paycheck for life starting in retirement. With a cash balance plan, you can choose whether you want annuity payments or withdraw or roll it over as a lump sum.
Not tied to investment performance
Participants in a defined are unaffected by market performance because they don’t actually invest their accounts themselves. Instead, they’re promised a fixed or variable interest rate and the employer bears all the risk of generating profits from investments to pay out the benefits.
Big tax deductions
Contributions to defined benefit plans are made with pre-tax income, giving you a tax deduction. With a cash balance, typical contribution amounts are between $100,000 to $300,000 per year, giving business owners the ability to deduct far more taxable income than with defined contribution plans.
Cons of defined benefits plans
No investment options for employees
If you’re an employee participating in a defined benefit plan, you don’t get to make your investments as you would be able to with a 401k.
No chance to increase your balance in retirement
With a 401k, you can potentially increase your account value by retirement by increasing your contribution amounts or making more aggressive investments. With a defined benefit plan, your account balance will never exceed the amount that was promised when the plan was set up.
Expensive and more complex to maintain
For employers, a defined benefit plan can be more complex and expensive to set up and maintain. However, this is usually offset by the tax savings, which in some instances can be tens of thousands of dollars per year.
Does a defined benefit plan make sense for you?
While pensions are losing popularity and have mostly been replaced by defined contribution plans like the 401k, a cash balance plan can make sense for you if you’re making mid six-figures per year and want to contribute over $100,000 in pre-tax income into a retirement plan.