Defined Benefit Plans: When the Numbers Make Sense

A traditional defined-benefit (DB) pension plan promises a specific retirement income, not a specific contribution. The employer (or owner-employee) must fund whatever is actuarially required to deliver that benefit at the participant's retirement age. For an older, high-income, owner-only business, the resulting contribution can exceed $400,000 per year — the largest single-vehicle deferral the tax code permits.

How the benefit is set

The plan formula typically reads: "X% of average compensation per year of service, payable as a single life annuity at age 65." Common formulas are 1.5%, 2%, or 3% per year of service. The §415(b) limit caps the annual benefit at the lesser of:

• $280,000 (2025), or
• The participant's average compensation for the three highest-paid consecutive years

For a 60-year-old physician with $400,000 of self-employment income and a plan formula targeting $280,000 at retirement age 65, the actuarial contribution can be $350,000+ per year for five years.

DB vs cash balance

Both are defined-benefit plans subject to §415(b). The differences are structural:

• Traditional DB promises an annuity; participant communications show monthly retirement income. Investment risk and reward stay with the plan (and ultimately the sponsor). Best for stable, owner-only or one-generation practices targeting a specific retirement year.
• Cash balance promises a hypothetical account balance with annual interest credits; participant communications show a lump sum. More portable, easier for participants to understand, more flexible if there are multiple owners with different ages.

For a solo practice with one owner, traditional DB often produces a marginally larger contribution at older ages because the cash-balance interest credit dilutes the funding requirement.

Funding obligation, the surprise

Unlike a SEP IRA or profit-sharing plan, which require zero contribution in a bad year, a DB plan requires the actuarially determined contribution every year — even in a loss year. The IRS minimum funding standard under §430 imposes excise taxes of 10% (climbing to 100%) on missed contributions under §4971.

Plan documents allow the formula to be amended downward going forward, but past accruals are protected. Closing the plan early to escape the funding obligation triggers IRS "permanency" scrutiny — a plan terminated within five years is presumed not to have been intended as a permanent retirement vehicle, and prior deductions can be disallowed.

When DB beats SEP / Solo 401(k)

The staff problem

A DB plan with rank-and-file employees must satisfy §401(a)(4) nondiscrimination testing and the §401(a)(26) "minimum participation rule" (at least 40% of employees or 50 people must benefit, whichever is less). For practices with significant non-owner staff, the staff contribution required to pass testing typically runs 7%–10% of pay — often deal-breaking. Solo or owner-spouse practices avoid this almost entirely.

Common mistakes

• Picking a benefit formula too aggressive to fund. A plan that requires $400,000 per year only works if the business produces $400,000 every year for five years. Sustainability, not maximum funding, is the typical design target practitioners use when modeling these plans.
• Forgetting the PBGC premium. Most professional service plans are exempt under ERISA §4021(c) — but verify. PBGC premiums are not cheap.
• Confusing the §415(b) benefit limit with the contribution. $280,000 is the maximum benefit, not the contribution. The contribution is whatever the actuary says is required.
• Underestimating exit cost. Terminating a DB plan requires either rolling lump sums to IRAs or annuitizing — and the wind-down can take 12–18 months.

Sources

• Internal Revenue Code §415(b), defined-benefit dollar limit (Cornell LII): law.cornell.edu/uscode/text/26/415
• Internal Revenue Code §430, minimum funding standards: law.cornell.edu/uscode/text/26/430
• Internal Revenue Code §4971, excise tax on funding deficiency: law.cornell.edu/uscode/text/26/4971
• IRS, "Defined Benefit Plan": irs.gov/retirement-plans/plan-sponsor/types-of-retirement-plans
• Pension Benefit Guaranty Corporation, premium filings: pbgc.gov/prac/prem
• Treasury Regulation §1.401-1(b)(2), permanency of qualified plans: law.cornell.edu/cfr/text/26/1.401-1

If you are 50+ with sustained six-figure self-employment income, ask RetirementCheck101 to size the DB opportunity. Explore the free educational tool.