TECHNICAL GLOSSARY

What Is a Defined Benefit Plan?

An established benefit plan, often called a pension, is an employer-sponsored retirement plan that guarantees all individuals meeting certain requirements will receive a specific amount each month upon hitting retirement age. This amount is determined ahead of time, using a formula, as opposed to relying on the performance of the invested funds of the individual.

This differs from defined contribution funds (401(k) or 403(b)) in that only employee contributions and/or employer matching and/or market returns will dictate the amount of income during the individual's retirement. With a defined benefit plan, the employer has the risk of the investments, as well as the responsibility for making contributions sufficient to meet the total of the retirement benefits promised.

Defined benefit plans are often found in the public sector (gov't job) or larger organizations (Lot of employees), but there are some private sector companies that also offer this kind of benefit.

How Defined Benefit Plans Are Taxed

Under IRS regulations, defined benefit programs are subject to a variety of taxes and tax breaks according to their categorization.
Employer Contributions
For most defined benefit plans, employers can usually claim a tax deduction whenever they contribute to the plan. Most defined benefit plans will not require employees to contribute; however, a few plans might allow for either mandatory or voluntary employee contributions.
Investment Earnings
Income earned through investments made by the pension fund receives tax-deferred status. This means that earnings will not be taxed while they are in the pension fund.
Distributions When Retired
Retirement distributions received after the participant's retirement will generally be considered regular income and taxed according to the retiree's tax bracket in the year the distribution is issued.
Distributions Before Age 59 ½
Any amount distributed to an individual before they reach the age of 59 ½ will generally be subject to both a 10% penalty for early distribution and regular income tax as well, unless the payment qualifies for an exception pursuant to IRS rules.
Required Minimum Distributions (RMDs)
In accordance with current IRS regulations, participants in most defined benefit plans must begin taking Required Minimum Distributions (RMDs) by April 1 of the year after they reach age 73. The administrator will determine the required distribution amount based on your life expectancy and the benefits afforded to you under the defined benefit plan.

How a Defined Benefit Pension Plan Works

Eligibility and Enrollment
Employees that are eligible at hire will usually receive automatic enrollment into their retirement plan; however, there may be plans that have a waiting period before eligibility to participate in the retirement plan.
Benefits Calculation
The benefit will be calculated based on a formula that usually contains:

• Length of service with the employer
• Average wage over a specified number of years; and
• The fixed percentage of the average wage.

The longer the employee works for the employer and the higher his/her wage, the higher the employee's retirement benefits will be.
Employer’s Contribution
Employers are required by law to make annual contributions to the retirement plan to keep the plan funded adequately. The amount of each employer's contribution will be determined by an actuary.
Vesting
Employees are vested one they have completed the required number of years of service for the employer. Once the employee is vested, he/she is entitled to the benefits that he/she has already earned, even if he/she leaves the employer before retirement.
Retirement Payments
Retirement benefits will be paid as a monthly payment for the life of the retiree; however, there are some plans that will make payments in another form, such as survivor benefits or lump-sum distributions.