What is a defined benefit plan?

A defined benefit plan is a retirement plan that promises each person a set benefit at retirement, usually figured from pay and years of work. The business must put in whatever that promise costs each year. The IRS describes it as a plan that provides a fixed, pre-established benefit for employees at retirement.

The promise sits in a formula written into the plan document. An enrolled actuary, an actuary enrolled by the federal Joint Board for the Enrollment of Actuaries, works backward from that promise each year to the contribution it needs, using the age, pay and service of each person in the plan. The IRS page for the plan type tells the business to have an enrolled actuary determine the funding levels and sign the actuarial schedule the plan files every year.

A cash balance plan is a kind of defined benefit plan that shows each person an account balance instead of a monthly pension.

What is a cash balance plan?

Yes. A defined benefit plan is a pension. Federal law uses one definition for a plan covering a single owner and a plan covering thousands of employees: a pension plan that is not an individual account plan. The IRS says a business of any size can sponsor one, including a business whose only worker is the owner.

Some funding, insurance and excise rules differ by plan size and type, so a small business plan is not run on exactly the same terms as a large union plan. The tax on a missed minimum contribution, for example, is set separately for a single-employer plan and for a plan that many employers run together.

No. A defined benefit plan is a retirement plan that qualifies under section 401(a) of the tax code, and its promise to pay a benefit is what defines it. An annuity is a contract an insurance company sells. A plan may buy annuity contracts to fund its promise, or it may hold stocks, bonds and funds in a trust instead.

A 412(e)(3) plan is the one kind of defined benefit plan funded only with insurance and annuity contracts, and the tax code sets strict conditions on it.

What is a 412(e)(3) plan?

Defined benefit plans are governed by the Internal Revenue Code and by ERISA, the federal pension law. The IRS enforces the tax rules, and the Department of Labor enforces the fiduciary and reporting rules. The Pension Benefit Guaranty Corporation (PBGC) insures many plans, but a small professional practice’s plan may not be covered.

The Department of Labor’s office for these rules is the Employee Benefits Security Administration. The PBGC insures most private defined benefit plans, but not all. A plan of a professional service employer, such as a medical, dental, law, accounting or architecture practice, is not covered if the plan has never had more than 25 active participants at any time after September 2, 1974. A plan maintained only for substantial owners, meaning owners of more than 10 percent of the business, is not covered either. Paying PBGC premiums does not make an excluded plan covered. Ask your enrolled actuary whether your plan is covered before anyone tells you it is insured.

The plan’s money and the trustee’s duties have their own page.

Who holds my money?

The IRS lists the defined benefit plan as the most costly and the most administratively complex type of plan. The contribution is mandatory each year within the actuary’s range, and an unpaid minimum is taxed at 10 percent, then 100 percent if it stays unpaid.

The employer bears the investment risk: benefits do not depend on asset returns, so a shortfall raises future contributions. The money is locked until age 59½, separation or plan termination, with a 10 percent additional tax on early distributions. Staff must be covered and credited under federal tests. Fees for the actuary, the administrator and the filings are paid every year.

What a bad year does, in order, is on its own page.

What are the risks?

Pension plans have been part of the federal tax rules for employer retirement trusts since the Revenue Act of 1926 added them. An earlier act covered only stock bonus and profit-sharing trusts. The rules a small business plan follows today sit in the Internal Revenue Code and in ERISA, the federal pension law.