How does one choose between a Defined Benefit Plan over a Defined Contribution Plan or vice versa?

The answer is that every employer has a different set of objectives, so the choice depends on the employer’s short- and long-term, financial goals, deduction needs, employee demographics, compensation history, or the need to establish an employee incentive program. Sometimes, the answer to this question is to have both a Defined Benefit and a Defined Contribution Plan where only selected employees participate in each program. Plans that cover only certain employees in a retirement program usually need to pass non-discrimination testing. Let us custom design a retirement plan that is right for you.



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A cash balance plan is a hybrid of a defined benefit plan and a defined contribution plan; however, it is classified in law as a defined benefit plan. The benefits under a traditional defined benefit plan are based on a fixed monthly benefit at retirement that considers the employee’s compensation and years of benefit service. However, a cash balance defined benefit plan looks like a defined contribution plan because the employee’s benefit is expressed as a hypothetical account instead of a monthly benefit.

Each employee’s “account” receives an annual contribution credit, which is usually a percentage of compensation, and an interest credit based on a guaranteed rate or some recognized index such as the 30-year treasury rate. At retirement, the employee’s benefit is equal to the hypothetical account balance which represents the sum of all contributions and interest credits. A notable distinction between a defined contribution plan and a cash balance plan is that the employer bears the investment risk for the underlying assets of the plan

An employer sponsored retirement program where benefits are based on fixed monthly benefit at retirement. The benefit provided considers the employee’s average compensation, years of benefit service, mortality rates, published rates of interest, and investment risk and return. Defined Benefit plans offer substantial tax deductions.

An employer sponsored retirement program where contributions are based on a predetermined formula. For 2010, the maximum dollar amount that an individual can receive is the lesser of 100% of their compensation or $49,000. If the plan is a 401(k) plan and the participant is “catch-up” eligible the dollar limit is increased to $54,500. Overall, an employer’s maximum tax deduction for the year cannot exceed 25% of total eligible compensation. The contributions made to the plan and any investments earnings thereon accumulate tax free until a distribution is made to the participant.

Employer contributions are allocated to participants in proportion to their compensation.

The objectives under this formula are to maximize the allocation of contributions for a specific group of employees (usually owners) and to minimize the contributions for other groups (usually non-owners). The groups can also be categorized by job description, title, hourly vs. salaries, etc. Because contributions are allocated disproportionately, non-discrimination tests are performed.

Employer contributions are allocated to participants using a formula that takes into consideration the Social Security Taxable Wage Base (SSTWB). In general, the way it works is that employees who earn below the SSTWB receive a lower share of the total contribution while employees who earn above the SSTWB receive a larger share of the total contribution. This formula favors higher paid employees. The rationale of an integrated formula is that compensation more than the SSTWB is disregarded in computing an employee’s social security benefits.

Employer contributions are based on a fixed formula stated in the plan document. Based on the stated formula, the employer is required to fund the plan accordingly.

A 401(k) Plan allows employees to defer a portion of their salary on a pre-tax basis. For 2010, an employee is allowed to defer a maximum salary amount of $16,500. Employees aged 50 and older may make an additional “catch-up” contribution of $5,500. In addition to the salary deferral arrangement under this plan, the employer has the option to also make matching contributions and/or profit-sharing contributions to all eligible participants. The contributions made to this plan are subject to non-discrimination testing.

The only difference between a Traditional 401(k) plan and a Safe Harbor 401(k) plan is that the deferral and matching contributions are not subject to non-discrimination testing. In exchange, the employer is required to make a “safe harbor contribution” which must also be immediately vested. The safe harbor contribution choices are:

  • a 3% safe harbor non-elective contribution, or
  • a safe harbor matching contribution of 100% on the first 3% deferred, plus 50% on the next 2% deferred.

 

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PURSUE YOUR INDEPENDANCE

Optimize Your Path

Let us help you reach your retirement goals