Suppose you are looking for a retirement plan that does not require contributions but allows a fixed income post-retirement based on your earnings or employment tenure. In that case, a defined benefit plan might work for you.
What is a Defined Benefit Plan?
A defined benefit plan is an employer-determined guaranteed retirement plan. This plan provides a fixed benefit, often based on an employee's earnings or career, to employees at the time of retirement.
According to this plan, employers can set up a pension fund for their employees which puts a fixed amount towards their retirement savings every year. The amount contributed is tax-deferred and is then taxable at distribution.
An employer can pay the retirement benefits in the form of:
- A pension. An employer pays a monthly income calculated per a fixed rate on an employee's retirement.
- A cash balance. An employer pays the entire amount as a lump sum.
Your employer needs to inform you about the plan's details to make an informed decision.
The total amount received by the employee is fixed and decided through a formula based on the employee's earnings or career.
Benefits and Drawbacks
The benefits of a defined benefit plan are:
- You, as an employee, do not contribute to the fund. The employer contributes and manages the pension fund for you.
- Your employer is responsible for the risks associated with the investment and planning of the fund.
- You receive a guaranteed income at retirement based on a formula that is fixed and easy to understand.
Some of the drawbacks of a defined benefit plan are:
- Employers generally avoid the plan as it involves substantial costs and a complex administrative procedure.
- You have less control over the contribution amount or your withdrawal period as the fund is entirely sponsored and managed by the employer.
- You might need to work for the employer for a long time to satisfy the pension plan benefits rules.
Choosing a Defined Benefit Plan
You can choose how to receive the retirement benefits in the following ways:
- A single lumpsum amount. You will be paid a single lumpsum amount at retirement.
- Monthly payments for life. You will get monthly payments calculated based on the length of your career or your income.
- An annuity covering yourself and your surviving spouse. You will receive a monthly payment for your lifetime, and after that, your spouse will receive at least 50 percent of the monthly payment for the rest of their life.
Calculating Defined Benefit Plan Payments
In a defined benefit plan, an employer decides on the amount for employees based on an agreed formula.
To determine the earnings for your benefits, you will need to average out the past couple of years' salary before retirement. In addition, you could also take the average of an employee's salary during their career. You can receive these earnings in either a lump sum or monthly payments.
An employer can calculate monthly payments in two ways:
- Pay a specific amount per month for retirement. For example, an employer deposits $150 per month for every year of the employee's service. If the employee has worked for 20 years on retirement, they will receive $3,000 ($150x 20) per month as a retirement benefit.
- Base retirement payments on the average income of an employee. Suppose an employee earns an average income of $5,000 per month. In that case, the employer can provide monthly retirement benefits like 20% of the average income, i.e., $1,000 (20% of $5,000) per month.
Maintaining Your Defined Benefit Plan
Although your employer controls and maintains the terms of your defined benefit plan, they still must follow specific rules:
- A contribution made to the fund is tax-deferred but becomes taxable at the time of distribution.
- No distribution of benefits before the age of 59 1/2 years.
- Requires reporting of the plan in Form 5500.
- An employer must have an enrolled actuary to determine the level of funding.
Takeaway
Employers can use a defined benefit plan to provide tax-deferred retirement benefits to their employees. It can be a secure way to meet your retirement goals. You can receive the benefits as a monthly plan or lump sum payment on retirement.