Defined Contribution vs. Defined Benefit Plans: What Business Owners Should Know
Choosing the right retirement plan can affect your employees, your business’s annual costs, and your overall tax strategy. Defined contribution plans, such as 401(k) and profit-sharing plans, offer predictable costs and relatively straightforward administration. Defined benefit and cash balance plans can allow business owners and key employees to build retirement savings more quickly while potentially providing significantly larger tax deductions.
In this episode of Ask an EBP Auditor, Ellen breaks down the differences between defined contribution and defined benefit plans, including how investment risk, contribution limits, tax advantages, and administrative requirements differ between the two.
Defined Contribution Plans
Defined contribution plans include 401(k) plans, 403(b) plans, and profit-sharing plans. Under these arrangements, employers and/or employees contribute a set amount, while the participant’s final retirement balance depends on investment performance.
These plans can be attractive to employers because they generally offer predictable, controllable annual costs and a lower administrative burden than defined benefit plans. Employer contributions, including matching and profit-sharing contributions, may also be deductible within IRS limits.
The trade-off is that employees bear the investment risk. Their account balances can increase or decrease with market performance, and there are requirements that can limit employer contributions or tax deductions.
Defined Benefit Plans
Defined benefit plans, including traditional pension and cash balance plans, provide a specific retirement benefit or benefit formula. The benefit is often based on factors such as age, service, and compensation.
One of the primary advantages of these plans is the potential for significantly larger tax deductions compared with defined contribution plans. Cash balance plans can also allow substantially larger contributions for owners and highly compensated employees, particularly those who are older.
The additional tax benefits come with greater complexity. Employers bear the funding and investment risk, and defined benefit plans typically require actuarial services and have higher administrative costs. Funding requirements can also fluctuate based on investment performance, interest rates, and participant demographics.
Tax Credits for New Retirement Plans
SECURE 2.0 provides tax credits that may help small employers offset the cost of establishing a new retirement plan. The startup cost credit can apply to both defined contribution and defined benefit plans, including cash balance plans.
The employer contribution credit, which provides a credit for certain employer contributions during the first five years, applies to defined contribution plans and does not apply to defined benefit plans.
Which Retirement Plan Is Right for Your Business?
The right plan depends on your business’s goals, workforce, cash flow, and tax strategy. A defined contribution plan may be a good fit for businesses looking for predictable costs and a simpler benefit structure. A defined benefit or cash balance plan may be more appropriate for business owners looking to maximize tax deductions and accelerate retirement savings while accepting greater funding requirements and administrative complexity.
For some businesses, combining plan types may provide an effective way to balance employee benefits, predictable costs, and retirement savings opportunities.
If you’re considering a new retirement plan or evaluating your existing plan, Boyum Barenscheer’s tax professionals and Boyum Wealth Architects can help you evaluate plan design, investment structure, and overall strategy.
View the transcript.