What Is the Unit Benefit Formula?

Unit benefit formula is a method of calculating an employer's contribution to an employee's defined benefit plan or pension plan based on years of service. Although a retirement plan that uses a unit benefit formula can reward employees for remaining at the company longer, it can also be more costly to implement for the employer.

Key Takeaways

  • The unit benefit formula is a method of calculating an employer's contribution to an employee's pension plan based on years of service.
  • The unit benefit formula means the company pays a percentage of the employee's salary, which might range from 1.25 to 2.5%.
  • An advantage of a retirement plan that uses a unit benefit formula is that employees are compensated for working longer at a company.

How a Unit Benefit Formula Works

A unit benefit plan is an employer-sponsored pension plan that provides retirement benefits based on a dollar amount or, more typically, a percentage of the employee's earnings for each year of service. The unit benefit formula means the company pays a percentage of the employee's salary for each year of service. A unit benefit plan is usually based on a percentage ranging from 1.25 to 2.5%. When the employee retires, their years of service are multiplied by the percentage multiplied by the career average salary to determine the employee's annual retirement benefit.

An advantage of a retirement plan that uses a unit benefit formula is that employees are compensated for working longer at a company. However, the unit benefit method requires the services of an actuary and, in turn, higher associated costs for the employer.

Defined Benefit Plan

A defined benefit plan is an employer-sponsored retirement plan where employee benefits are computed using a formula that considers several factors, such as length of employment and salary history. The company administers portfolio management and investment risk for the plan. There are also restrictions on when and by what method an employee can withdraw funds without penalties.

Defined benefit plans, which include pension plans or qualified benefit plans, are termed defined because employees and employers know the formula for calculating retirement benefits ahead of time. This fund is different from other pension funds, where the payout amounts depend on investment returns. If poor returns result in a funding shortfall, employers must tap into the company’s earnings to make up the difference. Because the employer is responsible for making investment decisions and managing the plan's investments, the employer assumes all the investment risk.

A tax-qualified benefit plan has the same characteristics as a pension plan, but it also gives the employer and beneficiaries additional tax incentives not available under non-qualified plans.

Qualified Retirement Plan

A qualified retirement plan meets the requirements of Internal Revenue Code Section 401a​​​​​​​, and so it's eligible to receive certain tax benefits. Such a retirement plan is established by an employer for the benefit of the company’s employees.

Qualified retirement plans give employers a tax break for the contributions they make for their employees. Qualified plans that allow employees to defer a portion of their salaries into the plan also reduce employees’ present income-tax liability by reducing taxable income. Qualified retirement plans can help employers attract and retain employees.

Contribution Limits for Qualified Plans

The Internal Revenue Service (IRS) has established annual contribution limits for employees enrolled in qualified plans such as 401(k)s. For 2020 and 2021, the maximum contribution limit for a 401(k)—as an employee—is $19,500. If an employee is aged 50 or older, they can make an additional catch-up contribution of $6,500 for both 2020 and 2021.

The IRS has also established annual limits for total contributions from both the employee and employer to a defined contribution retirement plan. For 2020, the total annual contributions to an employee's account cannot exceed $57,000 or $63,500, including $6,500 in allowed catch-up contributions for those employees aged 50 and over. For 2021, the total annual contributions to an employee's account cannot exceed $58,000 or $64,500, including catch-up contributions.