How are Defined Benefit Plans Taxed? Impact on Income and Payroll Taxes.

This article has been updated for 2024.

Introduction: How Are Defined Benefit Plans Taxed?

Defined Benefit Plans are a powerful retirement and tax planning tool. In this article, we will explain how Defined Benefit Plans are taxed.

We will start by describing how Defined Benefit Plans are funded and distributed. Next, how the employer and employee are taxed. Last, we will explain how Defined Benefit Plans may impact payroll taxes for small businesses.

Context: How Defined Benefits Are Funded and Distributed

A Defined Benefit Plan is a type of retirement plan.

However, unlike a Defined Contribution Plan, a Defined Benefit Plan provides covered employees with a retirement benefit based on a predefined formula.

Defined Benefits typically are paid for by the employer, and Defined Benefit rules require employers to pre-fund pension benefits in a pooled trust account.

To ensure adequate funding, the employer makes annual contributions to the Plan, as determined by the Plan’s actuary. Assets accumulate with annual contributions and investment gains, creating a pool of assets from which to pay future retirement benefits.

As eligible employees separate from service, they elect the form in which the employer will pay the benefit. Available forms may include a lump sum rollover, a lump sum cash out, or a lifetime monthly payment. Once the employee makes an election, the employer pays out the employee’s retirement benefit from the accumulated Plan assets.

For Small Businesses, the Owner is Both an Employer and Employee

We just have described how a Defined Benefit Plan is funded and distributed. Now, let’s explore this process for a small business owner.

To illustrate this, let’s use a one-person business as an example. In this case, the owner wears two hats – the employer and the employee. As the employer, the owner would adopt the Defined Benefit Plan. He or she also would predefine the retirement benefit on behalf of the only employee (the owner).

The owner (as the employer) would then make annual tax-deferred contributions to fund the employee’s benefit (i.e., the owner’s benefit).

Lastly, when the owner closes the business or terminates the Plan, he or she could elect, as the employee, to have their retirement benefit rolled over to an IRA. Moreover, as long as the assets were less than the maximum payout, the Plan could be amended to increase benefits such that all Plan assets are the employee’s (the owner’s).

How a Two-Person Plan Works: Owner and An Employee

Taking a slightly more complex example, let’s use a two-person business as an example. In this scenario, the owner would be the first employee and there would be one other non-owner employee. In such a situation, the owner, as the employer, would adopt the Defined Benefit Plan. He or she would predefine the retirement benefit on behalf of both the owner and the other employee. Note that the benefits need not be the same but the Plan must pass nondiscrimination testing.

The owner (as the employer) would then make annual tax-deferred contributions to fund employee benefits for both the owner and the other employee.

Lastly, if the owner closes the business or terminates the Plan, the corresponding benefits would be paid out to the owner and employee. However, if the non-owner employee separated from service prior to the Plan being terminated, he or she likely could receive a full payout of their benefit (most small Plans allow for immediate payment upon separation from service).

High-Level Overview: How Defined Benefit Plans Are Taxed

We just have explained how Defined Benefits are funded and distributed. With that as context, we will describe how Defined Benefit Plans are taxed for both the employer and employee.

• First, all permissible employer contributions are tax-deductible to the employer. Additionally, contributions made on behalf of employees to pay their future benefits are not taxable to the employee at that time.
• Second, investment gains on employer contributions are not taxable to the employer. They also are not taxable to the employee at that time.
• Third, benefits, which reflect all or a portion of past employer contributions and investment earnings, become taxable to the employee as ordinary income upon distribution. The employer is not taxed. If the benefit is paid to the employee as a series of monthly lifetime payments, the employee only is taxed as the payments are received. On the other hand, if the employee elects to receive a lump sum distribution, the entire payment is taxed unless it is rolled over. Of course, when an employee rolls over a lump sum distribution, the amount is not taxed until it is distributed from the IRA.

Having discussed how Defined Benefit Plans are taxed at a high level, we will explore each of these points in more detail. Additionally, we will discuss how payroll taxes may be increased for certain small businesses.

Defined Benefit Plan Contributions Are Tax-deductible

As mentioned, when pre-funding the Defined Benefit Plan, employer contributions up to the maximum annual limit are tax-deductible.

Moreover, employees are not taxed on the employer contributions that are made on their behalf. In fact, employees are not taxed until the distribution of their benefits.

Note that the maximum deductible contribution limit is very high. For example, it allows the employer to fund and deduct 150% of the existing unfunded Plan liability, as well as the unfunded value of the year’s benefit increases and future expected salary increases.

Investment Gains Are Tax-deferred

Unlike taxable accounts, realized investment gains in a Defined Benefit Plan are tax-deferred.

As you may be aware, the tax-deferral of investment gains may result in significantly higher retirement assets. This is because returns are compounded on returns. On the other hand, in a taxable account, asset gains are taxed each year. As a result, a portion of each year’s return may be needed to pay income tax. This reduces the asset base and the future expected asset returns.

The compounding in a deferred account is especially impactful over a long horizon.

Defined Benefit Assets May Be Rolled Over to an IRA

Upon separation from service or Plan termination, benefits may be paid to the employee (including the owner-employee).

If the employee elects a lifetime stream of monthly annuities or some other form of continuous payment, he or she is taxed on the payments for the year they are received.

Alternatively, many small Defined Benefit Plans allow the employee to receive a single sum payment in lieu of a monthly stream of payments. This single sum distribution can be rolled over to an IRA, further deferring income tax on the retirement benefit until amounts are withdrawn from the IRA. If, on the other hand, the funds are not rolled over to an IRA, the lump sum value becomes fully taxable to the employee. In all cases, pension benefits are taxed at ordinary income rates.

Defined Benefits Based on Earned Income

As described previously, Defined Benefits are based on predefined formulas. These formulas often are a function of pay, but, in all cases, Defined Benefit Plans are limited based on eligible Plan compensation.

For non-owner employees, this usually is not relevant because their cash compensation generally is W-2 pay.

However, for owners, this may not be the case. For example, a shareholder of an S Corporation may receive all or the majority of business income as a distribution rather than as W-2 pay. Why is this important? Because S Corporation distributions do not count as Plan compensation! Only W-2 wages do. Thus, the owner’s W-2 income will need to be large enough to support their targeted deduction.

In some cases, to support the targeted deduction, the owner may need to increase his or her W-2 income. This is especially true when the owner’s W-2 wage has been low relative to shareholder distributions. Of course, higher W-2 income means higher payroll taxes. At least temporarily. For example, if a CPA determines that the original W-2 income is reasonable, then increasing the owner’s W-2 for only three consecutive years often is sufficient to support the targeted deduction. After the three-year period, the W-2 wages could be lowered if the CPA believes the original amount is reasonable.

Of course, if the owner needs to increase their wages to support their targeted deduction, they will need to weigh the value of that deduction against the increased payroll taxes. Additionally, they will need to reflect that the higher W-2 wages may only be temporary (for up to three years).

Note that Sole Proprietors do not have this particular issue. Their net income (after retirement Plan deductions) is regarded as eligible Plan compensation.

Conclusion: How Are Defined Benefit Plans Taxed?

As described, Defined Benefit Plans provide significant tax savings to both employers and employees.

The ability to receive a large tax deduction that grows tax-deferred and can be rolled over at Plan termination makes a Defined Benefit Plan a powerful tax-planning strategy. This is particularly true for small businesses where nondiscrimination rules may allow tax savings that are significantly higher than the cost of providing staff benefits.