4 Things to Know About Defined Benefit Plans

1. Defined Benefit Plans Reward You for Years of Service.

Defined benefit plans are pension plans that reward employees based on years of service and associated salary earned. These retirement schemes pay out a set dividend amount upon retirement for the remaining life of an employee. Alternately, defined contribution plans are retirement plans that establish investment opportunities for employees based on employee and employer contributions. 

The set amount is determined from a formula using number of years of service, earnings history, and age. Typically, years vested is multiplied by pensionable earnings and divided by the set accrual rate. For example, for someone vested in a pension plan for 20 years, retiring at an average salary of $100,000, and a set accrual rate of 1/60th can expect $33,333 in pension yearly.

2. Defined Benefit Plans May Be a Good Option for Business Owners

For small business owners, defined benefit plans may be a particularly attractive retirement scheme. The IRS allows business owners to contribute up to 100% of average salary based on the highest three consecutive years or up to $210,000, whichever figure is the lesser amount. For small business owners making large salaries, near the $210,000 mark, defined benefit plans are a great tool to stockpile or quickly make up ground in retirement savings.

This type of plan may also be attractive to small business owners because the contributions are fully deductible as a common business expense.  For small businesses that face issues with high turnover, defined benefit plans can also add incentives for employee retention. When setting up these schemes, business owners effectively reward employees who stay with a company for a tenured amount of time. For employees who only stay short stints, the scheme is less beneficial.

However, it is important to note that defined benefit plans are relatively expensive to manage compared to alternate retirement schemes. Therefore it’s recommended that business owners have steady, strong cash flows and a relatively small number of employees before considering this plan.

3. You Have Options In How You Draw Your Pension

There are several options when considering how to utilize pension funds. The most standard way is to withdraw once an employee has met vesting requirements. Once fully vested, an employee can begin drawing pension benefits, whether or not the employee is retired. This typically happens at the age of 65, when employers stop contributing to plans. However, depending on verbiage in the scheme employees may have access as early as age 62. The pensions drawn from a defined benefit plan are taxed at the time of withdrawal, similarly to how traditional IRA’s are taxed. Roth IRA’s and other similar retirement plans, on the other hand, offer taxation before investment and thus are not taxed upon withdrawal.

Alternately, employees may be able to withdraw pensions as a lump sum. Employees facing financial distress due to illness, job loss, or family emergencies may consider this option. Many times there is verbiage in the plan that restricts this sort of access, however. For example, a plan may only allow lump sum withdrawal up to $30,000 dollars in funds or in $10,000 installments. Regardless, lump sums are subject to taxation as well; up to 25% of the pension may qualify as a tax-free withdrawal and the rest will face taxation.

4. You May Be Able to Borrow Against Your Pension Plan

Some pension plans include provisions that allow participants to borrow loans against their pension plans. The IRS regulates that up to 50% of the vested pension plan balance can be used to borrow against in the form of a loan. If your balance is less than $10,000 then the full amount may be borrowed against. The maximum limit is set at $50,000 and loan terms cannot exceed five years (except for the purchase of a home). Your plan administrator will set up regular payments of roughly equal proportion. Each payment will include principal and interest, with interest rates configured based on current market prime rates. Effectively, you’re borrowing money from yourself and paying yourself back on the loan plus additional interest.

For more information on Defined Benefit Plans, visit our website or contact us at TrueNorth Retirement Services.

At TrueNorth Retirement Services, we can help make your journey easier. We believe in honesty, reliability, and hard-work. As fee-only fiduciary advisors, we sit on the same side of the legal table as plan sponsors providing sound investment advice. We listen to plan sponsors and understand your challenges. Our goal is to understand your needs and then try to create a plan to address those needs. We appreciate the opportunity to assist you, your company’s retirement plan, and your participants. For a free financial consultation, please call: (801) 274-1768 or email info@tnrs.com.