What Are the Rules for an IRS Defined Benefit Plan?

A defined benefit plan, often called a traditional pension, is an employer-sponsored retirement plan that provides a guaranteed, specific benefit to an employee upon retirement. Unlike other retirement accounts, a defined benefit plan uses a set formula to promise a predictable stream of income for the retiree’s life.

These plans are governed by regulations from the Internal Revenue Service (IRS) and the Department of Labor to ensure they are funded and administered properly. The rules dictate everything from who can participate to how much can be contributed each year, making them a valuable but complex retirement tool for businesses.

Eligibility and Plan Design

Most business structures can establish a defined benefit plan, including sole proprietorships, partnerships, and corporations. While independent contractors are not eligible to participate in a company’s plan, they can establish their own as self-employed individuals. Employers must adhere to minimum participation and coverage rules from the IRS, which prevent plans from disproportionately benefiting highly compensated employees.

A plan must benefit the lesser of 50 employees or the greater of 40% of all employees or two employees. If a business has only one employee, that employee must be covered. Plans cannot set a minimum participation age higher than 21 or require more than one year of service, defined as working at least 1,000 hours in a 12-month period. These standards create a uniform floor for employee eligibility across all qualified plans.

Before creating the plan, a business owner makes several design choices that are formalized in the plan document. One decision is the plan’s normal retirement age, often set at 62 or 65. Another choice is the benefit formula, which dictates the pension amount and could be a flat dollar amount, a percentage of final average pay, or based on years of service.

The employer must also select a vesting schedule, which determines when an employee owns their accrued benefit. An option for these plans is a three-year “cliff” vesting schedule, where an employee is 100% vested after three years of service.

Determining Contribution Amounts

Unlike 401(k)s, contributions to a defined benefit plan are calculated annually by an enrolled actuary. The actuary determines the amount the employer must contribute each year to ensure the plan has enough assets to pay the promised benefits. This calculation establishes a required contribution amount for the current year, resulting in a funding range that gives the employer some flexibility.

The actuary considers several factors for each participant, including their age, years until retirement, and compensation. They also use the plan’s benefit formula and make assumptions about future investment returns, mortality rates, and employee turnover to determine the present value of all future benefit promises.

This method allows for large, tax-deductible contributions, which are made entirely by the employer. This is particularly true for older business owners who have a shorter time to fund their retirement benefit. For example, a 55-year-old business owner with high earnings requires larger annual contributions to fund their benefit compared to a younger employee in the same plan.

The maximum annual benefit a plan can pay at retirement is capped. For 2025, this limit is the lesser of 100% of the participant’s average compensation for their highest three consecutive years or $280,000. This benefit cap indirectly limits the amount that can be contributed and deducted each year, as the actuary’s calculations are targeted to fund a benefit no greater than this IRS-mandated maximum.

Plan Establishment and Administration

Establishment

To establish a defined benefit plan, a business owner works with a Third-Party Administrator (TPA) to prepare a written plan document and a trust agreement. The plan document outlines the specific rules of the plan, while the trust agreement creates a separate legal entity to hold the plan’s assets.

The business owner must provide the TPA with information to draft these documents, including:

• The employer’s tax identification number
• A complete employee census with full names
• Dates of birth
• Dates of hire
• Annual compensation for each employee

This data allows the actuary to perform initial non-discrimination testing and calculate the first year’s contribution requirements.

A business can adopt a plan for a given tax year up until its tax filing deadline, including extensions. For a sole proprietor on a calendar year, this means a plan can be established well into the following year. However, the plan must be set up and funded no later than September 15th of the year following the plan’s initial year.

Administration

A defined benefit plan requires ongoing annual administration to remain compliant. Each year, the plan’s actuary performs a valuation to determine the minimum required and maximum deductible contribution for the plan year. This is based on updated employee data and the investment performance of the plan’s assets.

After the actuary provides the contribution range, the employer must fund the plan. The contribution must be deposited into the plan’s trust account by the business’s tax filing deadline, including extensions, to be deductible for that tax year.

The final administrative step is the annual government filing. The TPA prepares and files the Form 5500 series return, which reports on the plan’s financial condition and operations. For defined benefit plans, the Form 5500 must include a Schedule SB, “Single-Employer Defined Benefit Plan Actuarial Information,” signed by the plan’s enrolled actuary.

Tax Treatment of Distributions

When a participant retires, distributions from a defined benefit plan are taxed as ordinary income in the year they are received. The funds grow on a tax-deferred basis, with no taxes paid on contributions or earnings until the money is paid out. The plan administrator will issue a Form 1099-R to the recipient, reporting the total distribution and the taxable amount.

Benefits are paid out in two primary forms. The most common is a lifetime annuity, providing a fixed monthly payment for the retiree’s life. Plans must also offer a qualified joint and survivor annuity option, which continues payments to a surviving spouse after the participant’s death. Alternatively, a plan may offer a single lump-sum payment, which is the actuarially determined present value of the future promised annuity payments.

A participant who chooses a lump-sum distribution can continue deferring taxes by executing a direct rollover to a traditional Individual Retirement Arrangement (IRA) or another eligible plan. Moving the funds directly to an IRA avoids immediate taxation and the mandatory 20% federal income tax withholding that applies to lump-sum payments. The funds can then continue to grow tax-deferred within the new account.