Defined Benefit Plan Vs Defined Contribution Plan for Small Business Owners
Navigating the entrepreneurial journey as a small business owner is no easy task. Planning for your financial security in retirement is of utmost importance, despite the number of obligations you shoulder every day.
There are many retirement plan types to choose from. Today we’re going to review two fine options when it comes to picking the best retirement plan: defined benefit plans and defined contribution plans.
One key difference between these retirement plans is that the employer is in charge of a defined benefit plan, whereas the employee is in charge of a defined contribution plan.
The main distinction between them is who is responsible for managing the assets, funding the plans, and, ultimately, ensuring that retirees have financial security.
This article will include the benefits and drawbacks for you and your business as a small business owner. Read on and learn more about the differences between each plan, and for sure, you'll be able to decide what would be suitable for the needs of your business.
Why Save for A Retirement Plan?
Estimates show that to maintain Americans’ current standard of living once they stop working, they will need between 70 and 90 percent of their pre-retirement income, which may seem high.
As an employer, you have to understand the importance of starting a retirement savings plan for yourself and your employees. Planning for this kind of investment will help you keep your employees in your business, attract qualified applicants, and even have the ability to save for the future and secure your business.
Tax Advantages
In addition, you will gain tax advantages by setting up a retirement plan. Here are the common tax advantages:
Employer contributions are tax-deductible.
Employee contributions (except for Roth contributions) are tax-deferred until distribution.
The money in the plan grows without being taxed.
Distributions can be rolled over or transferred into other retirement programs with tax advantages.
Incentives
Other than tax advantages, you may also have additional incentives as you establish retirement plans for your business as well as for you and your employees. Here are the following incentives you can benefit from:
High contribution limits for you and your employees to save substantial amounts for retirement.
"Catch-up" rules allow employees aged 50 and over to make additional contributions, with the amount varying depending on the plan type.
Tax credit for small employers, covering part of the costs to set up and manage a retirement plan, up to $500 per year for the first 3 years of the plan.
Saver's Credit is a tax credit available to certain low- and moderate-income individuals (including self-employed) based on their plan contributions, with a maximum eligible contribution of $2,000.
Option to add a Roth program to a 401(k) plan, enabling participants to make after-tax contributions and enjoy potential tax-free distributions after 59 1/2 years, disability, or death, if held for at least 5 years.
Defined-Benefit Plan
In a Defined Benefit Plan, also known as a "pension," you are promised a specific amount of retirement income based on a predetermined formula that considers factors such as your salary history, years of service, and age at retirement.
However, as the employer, you are responsible for funding the plan and managing the investments. This may sound like a burden, as you have to continue making contributions to the fund regardless of how the business is doing.
Once an employee retires, the company has to start funding their monthly benefits.
Types of defined benefit plans
There are three well-known types of defined benefit plans, namely:
Flat benefit plan
In a flat-benefit plan, employees receive a fixed and consistent retirement benefit throughout their retirement years. The benefit is usually based on a predetermined percentage of the employee's final average salary multiplied by the number of years of service with the company.
Unit benefit plan
A Unit Benefit Plan calculates retirement benefits based on a formula that considers the employee's years of service and salary history. The benefits are expressed as a specific number of units, and each unit's value may fluctuate depending on investment performance.
Variable benefit plan
In a Variable Benefit Plan, retirement benefits are directly tied to the investment performance of the plan's assets. The amount received in retirement fluctuates based on the returns earned by the invested funds.
Remember that Defined Benefit Plans are the only type of pension insured by the PBGC (Pension Benefit Guaranty Corporation).
As a small business employer, you are legally obliged to pay the guaranteed benefits. However, if your company fails to do so, the federal government steps in to help.
The insurance operates in a similar way to federal deposit insurance for bank accounts. If your plan is covered and your company faces financial difficulties, the PBGC will take over and make benefit payments up to a maximum amount.
Examples of defined benefit plans
Cash Balance Plan
Employees have individual accounts, much like in a defined contribution plan, and you as an employer make annual contributions to these accounts. However, the benefit formula used to calculate these contributions is typically based on a percentage of your employee's salary and years of service, similar to a traditional defined benefit plan.
Leave Salary
Your employees receive payment for their accumulated, unused leave days when they retire. The amount is based on their final salary and the number of leave days they have accrued over their career.
Gratuity
With Gratuity, you provide a lump-sum payment to employees as a token of appreciation for their long-term service. The calculation is typically based on their last drawn salary and the number of years they have worked for your company.
Voluntary Retirement Scheme (VRS)
As an employer, you can initiate a VRS to encourage employees to retire voluntarily before their official retirement age. They receive a one-time compensation package determined by their years of service and salary history.
Pension for Public Sector Bank Employees
Many public-sector bank employees have a Defined Benefit Plan for their retirement. The pension amount is determined by a formula that considers their service years, last drawn salary, and specific rules set by the bank or government.
Guaranteed Savings Plan
This type of plan, offered by certain financial institutions or insurance companies, provides a guaranteed return or payout at maturity. It ensures that employees receive a predetermined amount regardless of market fluctuations or investment performance.
Pros and Cons of Defined Benefit Pan for Small Business Owners
Pros
Guaranteed Retirement Income
With a Defined Benefit Plan, you can provide your employees with a guaranteed retirement income based on a specific formula. This assurance can lead to higher employee satisfaction and loyalty, as they know they will receive a stable income during retirement.
Tax Deductible Contributions
Employer contributions to the plan are generally tax-deductible, allowing you to reduce your taxable income while contributing to your employees' future financial security.
Higher Contribution Limits
Defined Benefit Plans often have higher contribution limits compared to Defined Contribution Plans. This means you and your highly compensated employees can save more for retirement, fostering a sense of financial security among your key personnel.
Benefit from Market Upside
As the employer, you bear the investment risk in a Defined Benefit Plan. However, if investments perform well, your employees can benefit from increased retirement benefits without making any additional contributions.
Cons
Complex and Costly Administration
Defined Benefit Plans require actuarial calculations and ongoing administration to ensure sufficient funds are available to meet future benefit obligations. The administrative complexity and costs can be higher compared to other retirement plan options.
Increased Funding Obligations
In certain economic conditions, you may be required to increase contributions to the plan to meet the funding requirements, which could strain your cash flow and impact business operations.
Limited Employee Control
Employees have limited control over the investments in a Defined Benefit Plan since you, as the employer, are responsible for managing the plan's investments. This lack of control may not align with the preferences of some employees, who prefer more investment choices.
Portability and Employee Turnover
Defined Benefit Plans may not be as portable as Defined Contribution Plans, making it less attractive to employees who change jobs frequently. This could be a drawback if you aim to attract and retain talent in a competitive job market.
Defined-Contribution Plan
In a Defined Contribution Plan, both you and your employees make contributions to your individual account. The final retirement benefit depends on the total contributions and how well your chosen investments perform.
You have control over where to invest your contributions, and the amount you receive in retirement will be based on how your investments grow over time.
The risk that comes along with this kind of investment is the fluctuation in investment return.
Defined Contribution Plan Category
The defined contribution plan category contains a broad range of plans, including profit-sharing plans, Safe Harbor 401(k) plans, Automatic Enrollment 401(k) plans, and Traditional 401(k) plans.
Profit Sharing
With a profit-sharing plan, you can make discretionary contributions to your employees' retirement accounts based on your business's annual profits. This allows you to share the company's success with your workforce while providing them with valuable retirement benefits.
Safe Harbor 401(k)
Safe Harbor 401(k) Plan: The Safe Harbor 401(k) Plan is designed to encourage employee participation by offering certain employer contributions that are immediately vested. By providing these contributions, you satisfy specific IRS requirements and make it easier for your employees to save for retirement.
Automatic Enrollment 401(k)
An Automatic Enrollment 401(k) Plan is designed to increase employee participation in the retirement plan. You automatically enroll eligible employees, making contributions on their behalf unless they choose to opt-out. This plan structure can help boost retirement savings among your employees.
Traditional 401(k)
The Traditional 401(k) is a widely recognized retirement plan that allows employees to make pre-tax contributions to their retirement accounts. You can also choose to match a portion of your employees' contributions, encouraging them to save for their future while reducing their taxable income.
Examples of defined contribution retirement plans
Employee Stock Ownership (ESOP)
This represents a unique form of defined contribution plan where the primary investments reside in your company's own stock. This plan structure empowers employees by giving them a stake in the ownership of their workplace.
Profit Sharing Plan
In a Profit Sharing Plan, you have the flexibility to decide, on an annual basis, the amount to contribute to the plan, which can come from profits or other sources. Within the plan, there exists a carefully formulated formula that distributes a share of each annual contribution to every participant, ensuring equitable participation in the plan's benefits. This arrangement allows employees to share in the company's success and financial rewards as the business prospers.
Employee Provident Fund (EPF)
By implementing the Employee Provident Fund, both you and your employees can make regular contributions to build a retirement fund.
National Pension Scheme (NPS)
The National Pension Scheme is a government-backed retirement option that allows your employees to invest in a mix of equity, debt, and government securities.
Unit Linked Insurance Plans (ULIPs)
ULIPs offer a unique combination of insurance and investment. Encouraging your employees to invest in ULIPs allows them to avail of life coverage while building a corpus for their retirement through market-linked investments.
Voluntary Provident Fund (VPF)
Offering the Voluntary Provident Fund as an extension of the Employee Provident Fund gives your employees the opportunity to boost their retirement savings with additional voluntary contributions.
Public Provident Fund (PPF)
Employees can benefit from the Public Provident Fund's long-term savings and investment opportunities. Encourage them to open PPF accounts to earn attractive interest rates and receive a lump-sum amount at maturity.
Life Insurance Pension Plans (Unit-Linked Pension Plans)
These plans offer both life insurance coverage and investment options. Suggesting these plans to your employees allows them to make regular contributions and enjoy potential market-linked returns for their retirement.
Pros and Cons of Defined Contribution Plan for Small Business Owners
Pros
Flexible Contributions
You have the freedom to choose the amount of contributions you want to make for your employees with defined contribution plans. This enables you to modify contributions in accordance with company performance and financial capability.
Employee Involvement
Employees frequently participate in investment decisions under defined contribution plans, giving them more control over their retirement savings. Giving employees investment options can increase their sense of ownership and engagement.
Portability
Employees can take their Defined Contribution Plan accounts with them if they change jobs, offering them greater flexibility and ease of managing their retirement savings.
Lower Administrative Burden
Compared to Defined Benefit Plans, Defined Contribution Plans typically have lower administrative costs and complexities, making it easier for you to manage your small businesses.
Tax Benefits
Employer contributions to Defined Contribution Plans are tax-deductible, providing potential tax advantages for your business.
Cons
Investment Risk for Employees
Employees in Defined Contribution Plans are responsible for managing their investment decisions, so they take on the investment risk. Their retirement savings may be impacted by bad investment choices or market fluctuations.
Uncertain Retirement Income
Defined Contribution Plans do not provide guaranteed retirement income, in contrast to Defined Benefit Plans. Employees' future income is uncertain because the final retirement benefit depends on contributions made and investment performance.
Employee Participation
Some workers might not put in enough money or participate in the plan on a regular basis to adequately fund their retirement. Employees might, as a result, fail to save enough for retirement.
Fiduciary Responsibility
You have a fiduciary duty as the plan sponsor to choose and oversee investment options because if they are not managed properly, they could expose your company to legal risks.
Limited Employer Control
Although you have some control over the amount of contributions, you have little influence over how employees handle their own accounts and investments.
Key Differences Defined Benefit Plans vs. Defined Contribution Plans
As a dependable option for both you and your employees, understanding the key differences between pension plans is crucial before making any investment decisions.
Defined Benefit Plan | Defined Contribution Plan |
Retirement benefits are predetermined based on specific calculations at the time of retirement. | Retirement benefits are not fixed and depend on the performance of the underlying assets. |
Generally considered advantageous for employees. | Typically considered beneficial for employers. |
Participation is usually automatic for eligible employees. | Participation in this plan is often voluntary for employees. |
Employees do not need to concern themselves with managing the underlying investment portfolio. | Employees must contribute to the plan and manage their investment portfolio. |
The employer holds the responsibility for making investments to fund the plan. | The investment risk lies with the employee, as the returns are not guaranteed. |
The Bottom Line
Start planning for retirement plans that best fit your business needs to retain employees, secure your assets, and take advantage of more benefits for the future of your business as well as personal financial security.
If you are looking for a business consultant to help you with your business and handle your retirement plans, look no further. Compass CPA, PC is dedicated to helping with any of your business needs, especially with accounting and taxes.
Reach out and learn more about Compass CPA, PC!