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Defined Contribution or Defined Benefit:
What is the difference?
Defined Contribution
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A defined contribution plan includes profit sharing and 401(k) plans.
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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.
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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
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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.
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The required contribution is actuarially determined as the amount necessary to fund the required benefit.
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There is no limit on the contribution into the plan. There is a limit on the benefits paid by the plan.
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The maximum benefit, for the 2021 plan year, is a life annuity of $230,000 per year, payable at age 62.
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There are certain compensation and service requirements necessary to receive the maximum benefit.
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In general, the closer a person is to retirement age, the larger the required contribution will be.
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It is possible to make contributions in excess of $305,000 on behalf of a participant.
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The investment risk always lies with the employer since the benefit is guaranteed.
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A participant’s benefit cannot vary based on performance of plan assets.
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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.
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There is no participant direction of investments. All assets are pooled and trustee directed.
Drawbacks of Traditional Defined Benefit Plans
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The contribution requirements often increase with salary increases.
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Older employees cost more than younger employees who earn the same amount.
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Partners/shareholders could have significantly different benefit/contribution levels.
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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?
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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.
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The maximum benefits are the same as for all defined benefit plans.
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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.
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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.
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Participants receive easily understandable statements showing the value of their account. Upon termination, their benefit is the value of their vested account balance.
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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?
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The benefit values are easier to understand.
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The benefits paid directly track to the contributions made to the plan.
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Age neutral contributions for employees
Good candidates for Cash Balance Plan
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Highly profitable companies that currently sponsor a cross-tested/new comparability 401(k)/profit sharing plan
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The owner's desire a larger tax deduction and the principals earn more than $290,000 per year.
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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.
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Family businesses
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The plan can be used as a component of succession planning.
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Closely-held businesses
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Several owners want a greatly enhanced retirement plan.
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Law firms and medical groups of all sizes
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Tax deferral and asset protection are often important to these professions. Cash balance plan assets are protected from lawsuit.
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Professional firms of all types
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CPAs, engineers, architects, etc.
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Older owners who have delayed saving for retirement
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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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