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Defined Contribution or Defined Benefit: 

What is the difference?

Defined Contribution


  • A defined contribution plan includes profit sharing and 401(k) plans. 


  • Once the contribution to the plan is made by the employer, all investment risk is placed upon the participants. The plan may permit participants to direct their own investments.


  • The most a participant can receive from all sources is $58,000 (plus $6,500 in catch up contributions if the participant is over 50) for the 2021 plan year.



Defined Benefit


  • A defined benefit plan promises a benefit funded by the company.  The amount of the benefit is determined by the terms of the plan document.


  • The required contribution is actuarially determined as the amount necessary to fund the required benefit.


  • There is no limit on the contribution into the plan. There is a limit on the benefits paid by the plan.


  • The maximum benefit, for the 2021 plan year, is a life annuity of $230,000 per year, payable at age 62.


  • There are certain compensation and service requirements necessary to receive the maximum benefit.


  • In general, the closer a person is to retirement age, the larger the required contribution will be.


  • It is possible to make contributions in excess of $305,000 on behalf of a participant.


  • The investment risk always lies with the employer since the benefit is guaranteed.


  • A participant’s benefit cannot vary based on performance of plan assets.


  • If the trust performs better than the assumed rate of return, the funding requirement will decrease in the following year. If the trust performs worse, the funding requirement will increase.


  • There is no participant direction of investments.  All assets are pooled and trustee directed.




Drawbacks of Traditional Defined Benefit Plans


  • The contribution requirements often increase with salary increases.


  • Older employees cost more than younger employees who earn the same amount.


  • Partners/shareholders could have significantly different benefit/contribution levels.


  • The benefits are difficult to understand or appreciate. For example, what is a single life annuity valued at $125 per month at age 62 worth when you’re 48?




What are Cash Balance Plans?


  • A cash balance, or hybrid, plan is a defined benefit plan where the benefits are expressed in terms of a guaranteed account rather than a guaranteed benefit.


  • The maximum benefits are the same as for all defined benefit plans.


  • Each year the participant’s hypothetical account is given a pay credit and an interest credit.  The pay credit can be defined as a percent of compensation, a flat dollar amount or some other non-discriminatory formula.  The interest credit can be a fixed percentage, or a variable rate tied to an index.


  • Because it is a defined benefit plan, the employer bears the investment risk.  This will result in actual contributions varying from pay credits as actual earnings differ from the interest crediting rate.


  • Participants receive easily understandable statements showing the value of their account.  Upon termination, their benefit is the value of their vested account balance.


  • Even though it looks like a profit-sharing plan, it is not.  Funding a cash balance plan is not discretionary and the required amount is determined by current funding rules.


What are the advantages of Cash Balance Plans over Traditional Defined Benefit Plans?


  • The benefit values are easier to understand.


  • The benefits paid directly track to the contributions made to the plan.


  • Age neutral contributions for employees

Good candidates for Cash Balance Plan


  • Highly profitable companies that currently sponsor a cross-tested/new comparability 401(k)/profit sharing plan

    • The owner's desire a larger tax deduction and the principals earn more than $290,000 per year.

    • Companies with principals that are older and highly paid and employees that are younger with lower wages will have the best non-discrimination testing results.


  • Family businesses

    • The plan can be used as a component of succession planning.


  • Closely-held businesses

    • Several owners want a greatly enhanced retirement plan.


  • Law firms and medical groups of all sizes

    • Tax deferral and asset protection are often important to these professions. Cash balance plan assets are protected from lawsuit.


  • Professional firms of all types

    • CPAs, engineers, architects, etc.


  • Older owners who have delayed saving for retirement

    • With the use of a cash balance plan, an owner can set aside 20 years of retirement savings in 5-10 years.

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