DEFINED BENEFIT PLAN: A Guide on How It Works as a Pension Plan and Its Tax Incentives

This comprehensive whitepaper offers an insightful guide into the workings of Defined Benefit Plans, commonly recognized as pension plans, which assure guaranteed retirement benefits for employees. Predominantly financed by employers, these plans calculate retirement payouts using a definitive formula, factoring in the employee’s age, length of service with the company, and salary. This document aims to elucidate the structure and benefits of Defined Benefit Plans, making it an essential read for understanding this key aspect of retirement planning.


A Defined Benefit Plan, a conventional pension plan model, ensures a fixed benefit for employees upon retirement, irrespective of investment performance. This type of plan is exclusively funded by the employer and stands out for allowing the highest possible contributions compared to other plans. One of the key advantages of these contributions is that they are not considered part of the employee’s current income and thus are tax-deferred until withdrawal. This plan is particularly suitable for employers seeking to provide substantial, tax-advantaged retirement savings for their long-term employees, making the Defined Benefit Plan an optimal choice for businesses committed to robust employee retirement benefits.

Higher Contribution Amount

Individuals planning for retirement can rely on an actuary to accurately calculate their prospective retirement payments, taking into account age, income, and tenure with the company. For 2022, the maximum annual retirement benefit is capped at less than $245,000 ($230,000 for 2021 and 2020; $225,000 for 2019), known as the dollar limit, or 100% of the individual’s average compensation over their three highest consecutive earning years, referred to as the compensation limit. This compensation limit excludes those whose annual benefits are $10,000 or lower.

For instance, consider Hal, who retires at age 65 from ABC Enterprises. His highest three-year average salary is $75,000. Therefore, he is eligible for a maximum annual benefit of up to $75,000, either as a life or joint and survivor benefit. In contrast, Mark, Hal’s colleague, also retires at age 65 but with a high three-year average salary of $200,000. Consequently, Mark can receive up to $185,000 annually as his retirement benefit. This example illustrates the variation in retirement benefits based on individual salary histories and the outlined limits.

Guaranteed Pension

Distinct from other plans where payouts hinge on investment performance, the Defined Benefit Plan offers a stable payout upon retirement, calculated through a precise formula. This ensures a guaranteed benefit, with the payout amount varying based on years of service or a specific percentage of earnings. An actuary is responsible for this computation, providing certainty in the retirement payout. In scenarios where funds are insufficient, the actuary recalculates contributions to secure the promised benefit. This plan’s reliability in providing a predetermined benefit, irrespective of market fluctuations, makes it a solid choice for individuals seeking a stable retirement income.

Tax-Deductible Contributions

The contributions are deductible from the income made by the business.

Tax-Deferred Contributions to Employees

Until the employees receive the payout, the contributions and earnings on the defined benefit plan will remain non-taxable.

Possible Integration with Social Security

As the IRS looks at the benefits from the Social security and a retirement plan as one, the higher-earning employees are entitled to a higher payout.  The lower-earning employees though don’t get left behind because they are still able to receive a higher percentage-of-salary benefit.  It’s just those who are earning more are favored within specific limits which is what we call permitted disparity.

Eligibility for a Loan

Participating individuals can be eligible for a loan. Loans from the plan can be made available but are not always allowed.  There are specific conditions that the loan must meet including:

  • The loanable amount should not be higher for high-earning employees than the other employees

  • The loan should follow the provisions set at the start of the plan

  • The loan should have a reasonable interest rate

  • The loan should be secured

How Does a Defined Benefit Plan Work?

Defined Benefit Plans are strategically crafted to incentivize employees to commit long-term to a company, often spanning years or even decades. As an integral part of employee benefits, these plans are primarily employer-sponsored. While commonly referred to as defined contribution plans due to potential funding from both employer and employee, it’s more typical for either the company alone or the employee exclusively to contribute to the plan.

As an employer-sponsored retirement plan, Defined Benefit Plans qualify for specific tax advantages under current legislation. This includes tax deductions for employer contributions and tax-deferred growth on investments. In comparison to 401(k) plans, where employees often contribute a significant portion, Defined Benefit Plans are predominantly funded by employers, although there are scenarios where employee contributions are also involved. This distinction underscores the plan’s role in providing substantial retirement benefits backed by employer support.


In a Defined Benefit Plan, retirement benefits are calculated using a specific formula that considers the employee’s age, salary, and length of service with the company. For instance, an employer’s plan might provide 1.8% of the employee’s average salary over the last eight years for each year of service. So, if an employee has worked for 15 years, they could receive a benefit equal to 27% of their average salary during that period.

The methodologies for calculating benefits in Defined Benefit Plans can vary. Some plans may base the calculation on the employee’s salary during their final five years of employment, while others might use the average salary throughout their entire tenure. Additionally, some plans offer a flat dollar benefit, such as $1,000 per year of service.

It’s important to note that most Defined Benefit Plans are subject to certain limits set by the federal insurance provided through the Pension Benefit Guaranty Corporation (PBGC). These limitations ensure that the benefits are secured and sustainable, aligning with federal standards for pension provisions.


The Defined Benefit Plan stands out as a potent tax-planning tool, offering significant tax savings for both employers and employees. This savings accrue tax-deferred and can be rolled over upon the plan’s termination, enhancing its financial appeal. Particularly beneficial for small businesses, these plans often allow for tax savings that outweigh the costs of providing employee benefits, thanks to non-discrimination rules. This aspect makes the Defined Benefit Plan an attractive option for smaller enterprises seeking to maximize tax efficiency while offering robust retirement benefits.

How Defined Benefit Plans are Taxed
  • The employer contributions can be debited from the income.

  • The employer contributions can be subtracted from the defined benefit plan.  There will be no tax associated for the employees for the contributions the employer pays.

  • The plan results in a tax deferral in assets.

  • The contributions and earnings through the defined benefit plan won’t incur an income tax until the time it is withdrawn.

  • Once the distributions have been done, there will be an income tax.

  • The distributed amounts are taxed the same year.

  • Distributions made prior to retirement may result in early tax.

Note: A participant who decides to withdraw his distribution before the age of 59 ½ can incur a 10% distribution tax (unless there is an exception) as well as a state penalty tax.

Minimal distributions are given after one turned 70 ½.

Owning 5% of the company means you as an employer should get minimal distributions once you reach the age of 70 ½ starting on April 1st of that year.  This should apply only if you already own 5% and more of the earnings or capital in the employer and more than 5% of the stock or power to vote of the employer.

When it comes to your employees, a different regulation follows.  The employees can receive distributions by the 1st of April of the year he or she reaches the age of 70 ½ and or the year he or she retires. 

Note: In some instances, even without retirement, one can receive payouts by April 1st of the same year the individual turned 70 ½.

Defined Benefit Plan Contributions Are Tax-deductible

Employer contributions (when pre-funding the Defined Benefit Plan) up to the maximum annual limit  are tax-deductible. Employer contributions made on the employees’ behalf are not subject to tax. Employees are in fact not taxed up until their benefits are distributed.

Take note that the maximum deductible contribution limit is exceedingly high. As an example, it allows the employer to fund and deduct 150% of the existing unfunded Plan liability, as well as the unfunded value of the year’s benefit increases and any expected salary increases in the future

Investment Gains Are Tax-deferred

In a defined benefit plan, the realized investment gains are tax-deferred (unlike in taxable accounts). These gains may result to significantly higher retirement assets because the returns are compounded on returns. This is in contrast with taxable accounts wherein asset gains are taxed every year. Consequently, a portion of the return each year may be needed to pay income tax which then reduces the asset base and any future expected asset returns. This makes the compounding in a deferred account particularly impact over the long term.


In general, a defined benefit plan is thought to be a pension which is an assured monthly benefit that commences at retirement based on a formula that factors in the employee’s tenure with the company and his salary amount.
There has to be a certain tenure period with the company for an employee to earn pension benefits. And once the required tenure is met, an employee is considered “vested”. There are different vesting requirements for a pension plan. As an example, after working for a company for a year, an employee might be 20% vested which makes him eligible for a retirement payment equivalent to 20% of a full pension.
Vesting schedules are also a usual part of defined contribution plans. Almost half of 401(k)s have some type of vesting schedule for employer contributions.
Cash balance plans are defined benefit plans that award an employee a set account balance upon retirement or once he leaves the company, as an alternative to a set monthly benefit. Because of this, many people think of them as a hybrid between traditional pensions and 401(k)s.
Employers, however, do not guarantee indefinite benefit payments despite taking on all of the investment risk related to managing retirement funds. An employee is instead assured only up to a certain cash balance.
Cash balance plans normally compute benefits based on the employee’s total working years with a company (and not just on his last or highest earning period) which implies that some people end up with less benefits if their companies change to a cash balance plan from a pension plan.
There are two factors that employers usually consider when calculating for the cash balance: pay credits and interest credits. An employee’s account is typically credited every year with a pay credit (like a 3% of compensation from the employer). The employee will also receive an interest credit for what’s in the account (like a fixed or variable rate linked to a standard such as the 30-year Treasury bond).
The employee would have a yearly account balance that is granted to him upon vesting and once he leaves the company. This gives the employee the chance to choose if he wants to receive the balance in the form of an annuity that makes regular payments over time or to take the benefit as a lump sum. This could also be rolled over to an individual retirement account (IRA) or to another company’s plan.


Who can set up a defined benefit plan?

Anyone who has a business can engage in the defined benefit plan.  Yet, it is still a whole lot beneficial for businesses that only have a small group of high-earning owners.  It is because the plan itself needs to have large contributions in which the current contributions will make up for older principals. 

The plan may work if you have younger employees.  As they have a long run to work, there will be ample years to fund the retirement benefits and they just require smaller contributions.

The traditional type of defined benefit plan is not a choice because of the downsizing that happened for some companies.  Most have favored 401(k) and other types of plan that is primarily funded by employee contributions.  If you cannot change the type of plan, why not convert it?  Many companies have ventured on converting their traditional benefit plan into cash balance.  The cash balance gives employees advantages and it is also a type of defined benefit plan that will be discussed separately.

Section 412(i) of the defined benefit plans may work with small business types or sole proprietors.  There will likely be larger onset deductions and the plan administration can be simple. 

What are the cons of the defined benefit plans?

1. The plan should be paid up to date even if the business is not earning profit. Even if the company is not having any profit from the plan, they are still obligated to fund the plan.  Being able to fund the plan is a must so if you are not ready to commit to funding it for years.  In such instances, the IRS can issue penalties if the plan is underfunded.

2. To determine the contributions, you will need the help of an actuary. As computations are necessary to know the amount you will have to deposit from time to time, you must get the service of an actuary.  An actuary will base the computations on the following:

– The benefits associated with the plan
– The age, income, age of retirement of the individuals participating
– The mathematical assumptions of:
– Interest to be earned
– Salary increase of the individuals participating
– The assumed rates of turnover, disability, and life of the individuals

3. There is a need to buy pension insurance. The existence of a defined benefit plan comes with required insurance coverage by the PBGC or Pension Benefit Guaranty Corporation.  The PBGC is a federal agency that insures that pensions are accumulated for each defined benefit plan.  If the employer fails to fund the plan, the PBGC will cover up the benefits in accordance with the plan provisions.
PBGC is an agency funded with the aid of premiums paid by employers-sponsors of the plans.  The premium is an annual flat rate for each participant and can have an additional if the employer has unfunded vested benefits.  Terminating the plan requires a notification to the PBGC as they need to approve the distribution of the plan assets to the participating individuals.

4. The plan’s maximum yearly benefit is restricted to employees who are under the plan for at least 10 years. The dollar limit which is set at $185,000 for 2008 decreases for individuals that retire earlier than the age of 62.  Moreover, the dollar limit is allowable for employees who have completed participating in the plan for 10 years.  Meaning, the employee’s years of participation are less than 10, it will automatically be reduced.  The same principle applies goes with the 100% compensation limit and the $10,000 exception wherein the benefit is decreased in accordance with year of service less than 10.

Say Jane is an employee of XYZ who joined a defined benefit plan at the age of 58.  She then retires at age 65.  Although her three-high average is $150,000, the computation shall be 7/10 x $185,000 which yields $129,500.

5. Participating individuals who get off the plan before retiring is only entitled to a smaller benefit. As we have known that the longer you stay in the plan, the more you will benefit from it.  So, if an employee decides to leave the plan he or she participated in, he or she will only get a small amount.  Also, if he or she is not vested, then he or she won’t likely receive anything from the plan.

6. The plan benefits cannot be carried with a different employer. Once an employee decided to leave the company and with an existing defined benefit plan, he or she cannot transfer the existing plan benefits to the company he or she is about to get into.

7. Top-heavy legal requirements will be needed for the plan. The IRC or Internal Revenue Code forbids those under the top management employees to get more benefits than those who are under low management positions.  We can also say that the plan is top-heavy once the current value of the accrued benefits of the employees on the top management is over 60% of the total benefits.  Once the plan is deemed top-heavy, it is required that a minimum of 2% of pay on each year of service (limited to 20%) should be allocated for the lower management employees wherein a certain vesting rule applies.

8. The plan should not be in favor of the highly compensated participating individuals. Generally, this may tell that the highly compensated employees (check Questions & Answers for definition) cannot benefit more from the plan than the non-highly compensated employees.  To be sure, nondiscrimination testing is done.

Note: Those under the local and state plans may not undergo discrimination testing.

9. The company must fill in the inadequately funded plan. In case during the duration of the plan shows that the assets will not be able to fulfill the payments associated with the plan, the actuary will re-compute to make the funds sufficient.  Some of the causes of the underfunding in the plan are the unsatisfactory performance of the investment and the employment of workers that require immediate funding.

10. The defined benefit plan requires disclosure and reporting. ERISA (Employee Retirement Income Security Act) together with the IRC (Internal Revenue Code) subjects the plan to disclosure rules and reporting.
Note: Those plans who are for the government and church are not covered by ERISA.

Which employees should you include in the defined benefit plan?

In general, the plan can be offered to your employees who are already 21 years old and up.  He or she should also have at least had 1,000 working hours from the previous year and have been in the company for 2 years.  The employer can prefer lesser years of service but with a more restricted rule.

Also, the plan you are going to setup should have the required number of participants.  It is said that the defined benefit plan should benefit the lesser of (1) 50 employees or (2) above 40% of the total employees or 2 employees.

In such cases that there is only one employee, it should benefit that one employee.

Note: Those who are under the state and local government plans are not included in this requirement.

What is the required minimum testing coverage?

To qualify, the plan should meet coverage tests that follow nondiscrimination in favor of high-earning employees.  If the plan covers the high-earning employees, it should also cover a minimum number of non-highly compensated employees.

Coverage tests vary but the basic one can cover any of all of the highly compensated employees and should also cover any of the non-highly compensated ones or at least 70% of the percentage of the highly compensated ones.

Sample Scenario: Let’s say that the plan can cover 100% of the highly compensated participants, meaning, the plan should also cover 70% of the non-highly compensated ones.  On the other hand, if the plan only covers 50% of the highly compensated employees, then the percentage of coverage for non-highly compensated ones is 35%.  (70% of 35% is 35%).

Note: Plans under the state and local government are not included in this requirement.

What includes compensation?

To better distinguish who can be tagged as a highly compensated employee, an individual’s compensation includes all taxable personal income which are salary, wage, fees, commission, bonus, and tip.  Salary deferral plans like 401(k) and salary reduction contributions to cafeterias are also taxable.

Do employees get full or part ownership of the defined benefit plan accounts?

In general, the employer must vest in 100% within 5 years or what they call cliff vesting or 20% within 3 years and followed by 20% each year until the full 100% vesting is done within 7 years or simply graduated vesting.  In top-heavy plans, a different rule is followed.  In 3 years, it should have 100% vesting (cliff) and 6 years for graduated vesting.  In cases that two years of service is required, there should be 100% vesting right after the two years of waiting.

Is a determination letter in favor of the plan is needed from the IRS for the defined benefit plan to qualify?

The answer is no.  There is no need to receive or get a favorable determination letter from IRS.  If the submitted plan met the IRC and ERISA requirements, it is then eligible for the tax benefits.  The good thing about seeking the approval of the IRS and getting a favorable determination letter helps in plan qualification beforehand.  An employer who didn’t seek for it may encounter problems like disqualified provisions not being able to be corrected because it’s already too late.  If you have a favorable determination letter in hand, auditors won’t typically point out the issue of plan qualification.

How do you know the benefits? How is it paid?

There is a certain formula by which the amount of retirement benefit can be derived.  That formula is already set and is influenced by the employee’s age, compensation, length of stay with the employer, or a combination of any of those.  In some instances, the calculation can be as simple as getting the product of the years of service to a flat dollar.  In addition, the calculation focuses on the final years before retiring rather than the previous years.  Depending on the employer, they may promise to pay for the employee’s yearly retirement equal to the three-year average.

When it comes to how the pension is paid, it doesn’t follow the same way as the 401(k) that gives each person an individual account, and the retirement value is based on the movement of investments and contributions.  The defined benefit plan comes from a pension trust fund where all of the plan’s assets hold as well including survivor benefits, retirement benefits, or disability benefits. 

How is a defined benefit plan set up?

1. Prepare a plan that will work for your business. To set up a qualified defined benefit plan, you will need the advice of a plan specialist as well as an actuary. Here are the steps by which you can develop the right plan for your business.

     a. Identify the plan that suits your business. How do you do that? First, you assess your business. Evaluate factors like profits, cash flow, tax deduction, number of employees (years of service, age, and income), and how your employees and you will benefit from the plan. With this, one can establish the features such as eligibility requirements, retirement benefits, etc.

     b. Select a plan trustee. The trustee can be you or another person. The reason for having a trustee is for someone to have the general responsibility for managing the plan assets, putting together the account statements, maintaining a checking account, collecting records of the contributions and distributions, tax report filing with IRS, and withholding the right taxes.

     c. Select the administrator. Being the administrator of the plan means a lot of responsibilities. This may include the management of the plan and participating in the disclosure and reporting requirements. Also, he or she has the authority to invest in plan assets or give educational services regarding investing to the participants of the plan. Although the employer or business owner can typically do it, the sponsors will usually get the service of a third-party firm or other financial services to do the administration of the plan. Just remember to follow the bonding requirements of ERISA.

2. Submit the plan for approval. Now that you’ve finalized the inclusions of the plan, it is time to submit it to the IRS for approval. As there are quite a number of requirements needed for the plan to be submitted, it is actually not required to be submitted to the IRS but is highly advised. See Questions & Answers. In the event that you submitted it, the IRS will then review it. If the plan fulfills the requirements, the IRS will send in a determination letter that says it is in favor of the plan. On the other hand, if the plan doesn’t meet the requirements, there will be an unfavorable determination letter that will be sent highlighting the inadequacy of the plan.

3. Implement the plan the same year it is made effective. Once the plan is deemed effective, the company should implement it the same year it has been approved. When it comes to a corporation, the implementation comes from the board of directors while with an unincorporated company, it is done through a written a resolution that is alike to the corporate one. So, before even submitting the plan for approval, be sure you have planned enough for the plan once it takes off.

4. Give out copies of the summary plan description to the entitled employees.
Once the plan has been implemented, ERISA advises the employer to provide their employees a copy of the SPD (summary plan description) within 120 days. The SPD will give out information about the plan’s provisions as well as the benefits, rights, and obligations of the participating individuals that are easy to understand. If there are also new participants along the way, the employer should also give them a copy within 90 days. Summaries of the material modifications should also be made available by the employer for the current and past employees. This information can be sent to the employees through email or the company’s internal website.

5. Submit a yearly report with the IRS.
With the implementation of the plan comes the employer’s responsibility to file a yearly report (called Form 5500 series return/report) with IRS. For more information, please seek advice from a tax or retirement plan specialist.

When should the participation in the plan start?

The participation of the employee who met the requirements begins not later than the earlier of:

The first day of the plan year when the employee reached the years of service and age requirement

Six months after the requirements are fulfilled


What do you mean by a highly compensated employee?

According to the IRS, a highly compensated employee (HCE) is anyone who has done one of the following:

  • Owned more than 5% of the interest in a business at any time during the year or the preceding year, regardless of how much compensation that person earned or received

  • Received compensation from the business of more than $130,000 if the preceding year is 2021 (and more than $135,000 if the year is 2022), and, if the employer so chooses, was in the top 20% of employees when ranked by compensation.

What is Section 412 (i) defined benefit plan?

Section 412 (i) defined benefit plan is the sole benefit plan which is excluded from the requirement of minimum funding of the IRC. The funding should come from the insurance contracts (can be in a form of annuity products or life insurance or a combination of both) from an insurance company.  The benefits should still be in accordance with the values in the contract.

There are advantages with Section 412(i) benefit plan which are as follows:

  • Have the probability for a larger initial income tax deduction as compared with the traditional plan (due to the assumptions in funding being more conservative)

  • Plan facilitation is simpler

  • Retirement benefits provided are ensured by the insurance company

Note: There is no policy loan allowed under the contracts.

How does the performance of plan investments affect the plan itself?

There is a possibility that the investment does well and may be able to fund the promised benefit.  If this happens, the contributions of the employer can be suspended for a certain time.

What does IRS do when the defined benefit plan is not able to meet the requirements?

In the event that there are defects in the plan, the IRS has its programs to be able to correct the defects.  With the aid of programs that help in correcting the defects comes less severe sanctions.  But if the correction is not done, it may result in disqualification of the plan.  The disqualification could yield the following:

  • Possibility of employees being taxed on the accrued benefits when vested instead of when it is paid

  • Deferred deductions for employer contributions

  • Earnings will be taxed and paid by the plan trust

  • The payouts won’t be subject to special tax treatment and won’t be tax-free


Now is the ideal time to begin your retirement planning journey! With a combination of Social Security benefits, investment income, personal savings, and potential pension income, you can build a secure foundation for your retirement years.

At Credo, our expert team is dedicated to helping you navigate and maximize your Defined Benefit Plan. We’ll guide you through the necessary steps to ensure you’re leveraging your plan effectively for a comfortable retirement. Don’t wait – contact us today to explore how you can optimize your retirement strategy!



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