Defined Benefit Plan | How are Defined Benefit Plans taxed?

What is a Defined Benefit Plan?

A defined benefit plan, which is a pension plan, is an employer-provided retirement plan that guarantees that qualifying employees will be paid a fixed monthly benefit when they retire. Unlike Defined Contribution Plans such as 401(k) or 403(b), where the final retirement benefit is only funded by contributions and investment performance, the defined benefit plan determines ahead of time the amount that an eligible employee will receive.

How are Defined Benefit Plans Taxed?

A defined benefit plan is taxed based on contributions, investment growth, and distributions because it takes contributions from the employer.

The following is an analysis of how defined benefit plans are taxed.

Employer Contributions: Employer contributions are typically tax-deductible on the employer side. Parallel to what is seen in defined-contribution plans, employees make no contributions to a defined-benefit plan.
Earnings: Investment earnings are taxed when the funds come out of the program.
Distributions are generally taxed as ordinary income, with most individuals, when received from a plan-defined benefit. Taxes are owed based on the recipient’s tax bracket in the year of distribution.
Early Withdrawals: A defined benefit plan distribution can be selected by an employer prior to age 59 1/2, but the payment may be subject to a 10% early withdrawal penalty in addition to ordinary income tax.
Required Minimum Distributions: If entering the defined benefit plans as an employee, minimum distributions have to begin by April 1 of the year after you turn 72, or in certain cases, that turn will hit before January 1, 2020. Then you need to take those distributions at age 70½. The company calculates the amount of distribution you must make based on your life expectancy and what is left in the plan.

How Does a Defined Benefit Pension Work?

Here is how a defined benefit pension works:

Auto Enrollment: The employer automatically enrols eligible employees in the plan. However, employees may have to wait a period before they can participate in some plans.
Calculation of Benefit: A formula based on a percentage of the employee’s average salary over X number of years of service is used to calculate a benefit. An employee who’s been at an employer longer will have a greater retirement benefit.
Contributions: Employers should make contributions on a yearly basis to ensure that there is enough money in the plan to pay for the promised benefits. Sometimes, employees also have to contribute to the scheme.
Vesting: Employees must complete a certain number of years of service to be vested in the pension plan. Upon vesting, they are entitled to the retirement plan benefits the project promised when joining, even if separating from that employer before reaching retirement age.
Retirement — Employees are eligible to begin receiving retirement benefits when they reach retirement age. Certain plans may offer employees a reduced benefit amount should they choose to retire prior to then.
Payment: An individual may receive retirement benefits monthly for the remainder of their life; other plans can provide payout options.