Defined Contribution vs. Defined Benefit Plans: What Business Owners Need to Know

Hi everyone, I’m Ellen with Boyum and welcome to another episode of Ask an EBP auditor. Today we’re answering a common question from business owners. What’s the difference between a defined contribution plan and a defined benefit plan? And what risks and tax advantages come with each? Let’s dive in.

Defined Contribution Plans

Think of your 401ks, your 403bs, a profit sharing plan. In these plans, the employer and/or employee contributes a set amount each year and the final balance at retirement completely depends on investment performance, meaning the employee bears the investment risk.

Why do employers like them? They’re predictable. They have controllable annual costs. Typically, they have a lower administrative burden than defined benefit plans. Employer contributions, including match and profit share, are deductible within IRS limits, and they can provide meaningful annual tax savings, and they’re popular with employees because they’re portable and easy to understand.

The trade-off, employee balances rise and fall with the market, so the employee absorbs the uncertainty. Additionally, there are some fairly strict requirements limiting the company’s contributions or their tax deduction.

Defined Benefit Plans

Now, these are traditional pensions and they are making a comeback with small businesses. They can include both classic pension plans and increasingly popular cash balance plans. In a defined benefit plan, the employer promises a specific retirement benefit. It’s often based on age, service, and compensation. Cash balance plans promise pay credits on the participant account balances.

What does this mean? There’s a much larger potent tax deduction. Defined contribution plans cap employer deductions at 25% of eligible compensation limited to 70,000 per employee. Defined benefit plans, however, allow deductions for whatever is actuarially required to fund the promised benefit up to the significantly higher Section 4040 limits. It’s oft 100,000 to 250,000 per employee depending on age, compensation, plan design.

There’s accelerated savings for owners and key employees in a defined benefit plan. Cash balance plans can direct substantially larger contributions to owners or highly compensated team members, especially those who are older.

Contributions for non-key employees can be designed to remain very manageable for the employer. Now the employer does bear the financial and investment risk in a defined benefit plan. There are higher administrative costs.

Traditionally defined benefit plans will require an actuary to calculate annual funding requirements and actuarial services must be paid by the employer not from plan assets. Funding requirements can fluctuate. Contributions will vary year to year because they depend on investment performance, interest rates, and participant demographics. And there is a balance sheet impact.

Traditional defined benefit plans can create balance sheet liabilities that affect financial ratios that could be important for lending or investment decisions. Cash balance plans typically have a lighter balance sheet impact. In short, defined benefit plans offer major tax advantages but come with less budgeting certainty and more complex administration.

Tax Credits

Now, a note on tax credits. Secure 2.0 provides two valuable credits for small employers starting a new plan. There’s the startup cost credit which helps offset plan setup and administrative expenses and it applies to both defined contribution and defined benefit plans and that includes cash balance plans.

The employer contribution credit which provides up to a,000 per employee for employer contributions in the first 5 years applies only to defined contribution plans. Defined benefit plans do not qualify for this credit.

Which Plan Is Right for Your Business?

So, which plan is right for your business? A defined contribution plan is great if you want predictable costs and a simple, easy to administer benefit structure. A defined benefit plan is ideal if you want to maximize tax deductions and rapidly build retirement wealth, especially for owners and key employees, but are comfortable taking on the funding and investment risk.

And for many businesses, a combo approach could deliver the best of both worlds. Now, if you’d like help determining which plan aligns with your goals, feel free to reach out. We have excellent tax experts and Boyum Wealth Architects can partner with you on plan design, investment structure, and overall strategy. See you next time.