Defined Benefit Retirement Plan [Strategies + IRS Hazards]

We know it is tough to understand how a defined benefit retirement plan works. In this guide, we will show you how they work and point out a few tips along the way.

In a defined contribution plan, the benefit upon termination of employment is the vested percent of the participant’s account balance. The vested percent increases with service, generally reaching 100% by the seventh year.

In a defined benefit pension plan, the account balance is replaced by the concept of an accrued benefit. A participant accrues (or earns) a portion of his projected benefit at retirement each year that he is in the plan.

A joint and survivor annuity pays a monthly amount during the life of the participant and a reduced amount (usually 50%) upon the participant’s death for the remaining life of the spouse. Both the spouse and the participant must consent in writing to waive this form of benefit calculation if the participant wants to take a lump sum or other form of an annuity.

Tax Deductions Available for a Defined Benefit Pension Plan

The private sector enjoys better tax treatment than the public sector because the employer funds most pension plans in the private sector and employees in the public sector.

For a plan to qualify for tax deductions, it must meet the minimum standards set on participation, vesting, and non-discrimination against low-paid employees. These requirements help regulate pension plans. Going against the requirements means the employer’s contribution will be considered a taxable income on the employee to be tax-deductible for the employer.

This article will discuss how contributions, investment income, and benefit payments are treated when it comes to taxation in a defined benefit pension plan.

Defined Benefit Retirement Plan Contributions

Corporate income tax allows employer contributions and wages to be deducted from business expenses. Employer contributions are also not taxed as income to the employees under personal income and Social Security payroll taxation.

But employee contributions are generally taxable for personal income taxation and Social Security payroll tax; contributions by an employee to salary reduction plans are not taxed.

However, limits are set for defined benefit plan contributions to protect the Treasury against excessive tax deductions. Limits are calculated on maximum employee earnings used to determine contributions or benefits.

Investment Returns

Once employers and employees have contributed to a defined benefit plan, they invest assets to grow their funds; earnings from these investments are not taxed. Assets maintained by the plan are also not taxable.

However, in the event of a termination of the defined benefit plan and the employer gains on surplus plan assets, the surplus is subjected to a corporate tax income plus an excise tax at 20%. It may rise to 50% if the employer does not transfer the excess assets to the replacement plan or increase the plan benefits to the participants. Excise tax helps discourage employers from misusing plans and discourage firms from terminating defined benefit plans.

Distribution of Benefits
Benefits from a defined benefit plan are received at retirement or earlier and are subject to federal and state personal income taxation. However, they are exempted from the Social Security payroll tax.

A participant also recovers the amounts that have previously been taxed. Progressivity of the income tax system allows a participant to pay lower taxation in retirement than when continuously taxed on income when working. An excise tax is also incurred when one takes lump-sum benefits before retirement. Excise tax discourages early distribution as pension plans are designed to generate retirement income.

Terminating a plan?

In many situations, business owners are so eager to fund a plan that they don’t realize the permanency of the plans. Defined benefit plans are not elective. So you cannot start and stop the plan as you see fit.

Companies are often hesitant to adopt plans because they are more expensive and complex to understand. Plus, they do require the company to commit to annual funding requirements. This can scare away even the most cash-rich companies. But the tax savings will often outweigh any other downsides.

Sharpened colored pencils

The IRS assumes the plans are permanent and can only be changed or terminated based on particular situations. The main hurdle to closing a plan is demonstrating “business necessity.” The owner cannot simply say that they wish to terminate the plan for no apparent reason. This typically will not go over well with the IRS.

A valid reason would be an unforeseen reduction in profits, a change in ownership structure, or a significant difference in cash flows. On occasion, the IRS has allowed termination due to adopting different retirement plans. A company may be able to demonstrate that a different plan is more suitable for the business.

The IRS also states that a plan should be for a “few years.” But what does this mean, and how is it defined? The IRS will not question a termination that occurs at least ten years after the original plan adoption. Companies that terminate plans in the 5-10 year range have not faced much pushback from the IRS.

How does the calculation work?

Furthermore, the calculation is repeated each year, considering the plan’s past investment experience, assumptions about future participant compensation increases, and assumptions about the plan’s future investment performance.

Contributions to defined benefit plans are required each year and may change yearly. Except for changes in the covered participants, the contribution changes are based principally on how well or how poorly plan assets perform and whether or not the performance meets the growth assumptions underlying the annual actuarial calculation.

The employer assumes the investment risk in a defined benefit plan, and the employer1 generally makes all contributions. The employer is charged with the responsibility to fund the plan adequately, despite the plan’s investment experience.

Financial planning puzzle piece

If the investment returns are good, the required employer contributions will tend to decline. If investment returns are poor, then contributions will increase.

Employers must make the required contributions to adequately fund the required benefit, regardless of the participant’s age at plan entry. A defined benefit plan’s contributions are disproportionately higher for older employees than younger employees.

Because older entrants to the plan normally have fewer years of plan participation before they retire, a larger portion of annual contributions goes towards providing benefits for them. Although younger employees will receive their promised benefit, they are not favored in terms of a defined benefit plan’s allocation of contributions.

Benefit calculation

Benefits under defined benefit plans are often, although not always, stated in terms of a percentage of the participant’s final compensation. In such a case, the higher the level of the participant’s compensation, the greater the plan contribution must be to fund the participant’s retirement income. To illustrate, assume that two employees, age 45, participate in a defined benefit plan promising to pay a retirement income of 60% of their final compensation.

Employee A earns $50,000 annually, and employee B earns $100,000 annually. Without considering their likely compensation growth, if each of these two employees continued to earn the same income until retirement, employee A could look forward to receiving a monthly retirement income of $2,500. ($50,000 X 60% = $30,000 ÷ 12 months = $2,500).

Employee B could expect to receive a monthly retirement income of $5,000 each month. The employer would need to make substantially higher contributions—perhaps double the amount—to fund employee B’s benefit.


A defined benefit pension plan becomes attractive when an employer or employee receives a tax benefit for deferring compensations. Tax deductions should be enjoyed by both the employer and the employee to encourage plan preference.

Constraints to overfunding and an early lump-sum withdrawal should be eliminated to increase the tax advantages under defined benefit plans.

PBGC Coverage Exemption: The Complete Guide

PBGC covers all defined benefit plans. Only those plans meant for substantial owners are exempted from this coverage. Including even one, not notable employee eliminates a plan from qualifying for the exemption.

  • A substantial owner meets the following requirements;
  • 100% ownership of the unincorporated trade or business
  • Direct or indirect ownership of 10% or more of a capital interest in a partnership
  • Direct or indirect ownership of 10% or more of profit interest in a partnership
  • Own 10% or more voting rights of a corporation
  • Own 10% or more of a corporation’s stock value

The ownership attribution rules mainly used to determine controlled groups also apply when ascertaining the stock ownership. Under these rules, stock owned by an owner also belongs to their spouse. Therefore, the owner-only exemption will apply if all participants are substantial owners or their spouses. Children of a significant owner are not attributed to stock ownership. Including them in a benefit plan eliminates the plan from PBGC coverage exemption.

Different plans may also have rules that may change a plan’s reporting or testing requirements but do not specify the PBGC coverage exemption. Some plans are exempted from filing Form 5500 or prefer to file Form 5500-EZ compared to Form 5500-SF or the standard Form 5500. Filing Form 5500-EZ requires that:

  • The plan covers the 100% owner of the unincorporated or incorporated business or only the partners in a partnership.
  • The plan may include the business owner’s spouse or partners’ spouses.
  • No other employee is covered.

Filing Form 5500-EZ does not require ownership of more than 10% of the employer compared to PBGC’s substantial owner exemption. This means that not all eligible plans to file Form 5500-EZ qualify to be exempted from PBGC coverage.

Non-discriminatory testing also considers a 5% ownership of an employer as a Highly Compensated Employee (HCE). PBGC coverage exemption requires a 10% ownership. Therefore, it is not enough for a defined benefit plan covering all HCEs to claim an exemption.

Suppose a PBGC-covered plan terminates without enough assets to distribute to all beneficiaries. In that case, PBGC allows the majority owner to waive a portion of his benefits to be distributed to other participants for their exclusive benefit.

A majority owner, in this case, owns 50% or more of the employer, which is different from the 100% ownership requirement when determining a substantial owner for PBGC coverage exemption.

Cash Balance Plan for Small Business [Top Strategies + Hazards]

When people think of retirement planning, they usually think first of a 401(k) plan or a SEP. These plans can be great options. But have you ever considered a cash balance plan for small business owners?

Most 401(k) plans have contribution limits that fall far short for many business owners. A cash balance plan should be considered because they have contribution limits that can often exceed $300,000 annually.

However, before we look at the details of the cash balance plan, let’s first examine the two main types of retirement structures: cash balance plans and defined contribution plans.

Cash Balance Plan for Small Business

A cash balance plan aims to provide eligible employees with a specified benefit at retirement. The benefit amount is contributed solely by the employer. It’s a specific amount that considers participants’ salaries and ages. Upon the normal retirement age of 62, the employee can take the money out of the plan and pay tax at the employee’s ordinary tax rate or roll the funds into an IRA.

In contrast, defined-contribution plans (such as 401(k) plans) specify a maximum contribution that can be made by the employee (as a deferral) and the employer. In a defined contribution plan, the benefit amount at retirement depends on the cumulative plan contributions and interest income, and investment gains or losses. 

How do cash balance plans work?

The most popular type of cash balance plan is the cash balance plan. Even though it is a cash balance plan, employee contribution amounts and the account balance feel like a 401(k) plan.

The payout is an account balance compared to a monthly income payment presented in a traditional cash balance plan. For this reason, cash balance plans are often referred to as “hybrid” plans. Like 401(k) plans, cash balance plan distributions are taxed at the taxpayer’s ordinary tax rate upon distribution.

However, cash balance plans allow the employee to take a lump sum benefit equal to the vested account balance. If a retiree or terminated employee desires, a distribution can generally be rolled over into an IRA or to another qualified plan.

But the surprising part is that these plans work great for small owner-only businesses and employers with less than 20 employees. They are a little more complex to set up and administer. So careful planning is imperative when setting up a cash balance plan for small business.

Why are cash balance plans so popular?

They allow the business owner to make substantial tax-deferred retirement contributions. Contribution limits are indexed and adjusted annually based on age. But annual contributions can often exceed $300,000, with $150,000 being the approximate average. This compares very favorably to the yearly limitations of a 401(k) plan.

Let’s take a look at an example. Assume a 56-year-old physician makes $500,000 a year and wants to maximize their retirement contribution. Let’s also assume that the physician has no qualifying full-time employees.

chart with finance, tax and debt, Cash Balance Plan for Small Business

Because of age and earnings, this doctor could contribute up to $230,000 to a cash balance plan in the first year. The doctor can make additional contributions if the cash balance plan is combined with a solo 401(k). Not such a bad deal.

These contributions are fully tax-deductible and can be made up to the date the tax return is filed (including tax extensions). The contributions will grow tax-deferred but will be subject to tax at the presumably lower tax rate in retirement.


Due to their low costs and light administrative requirements, defined contribution plans increasingly gain a considerable following. But many organizations still opt to continue providing defined benefit plans. Here are a few things to consider:

Prepare for increased costsCash balance plans have higher fees compared to defined contribution plans. Sponsors should be ready to cover economic costs, benefit costs, administrative fees, Pension Benefit Guaranty Corporation premiums, and investment management expenses.
Plan contributionsSmall businesses should ensure that the business generates enough income to support high contributions under a defined benefit plan. Skipping a contribution increases subsequent contributions and general plan costs.
Plan liabilitiesOpportunities like small-amount bulk-sum sweeps or an ongoing lump-sum offer are effective and cost-efficient ways to help a sponsor reduce liabilities in a cash balance plan.
Investment strategiesA plan investment strategy should align with the plan objectives and acceptable investment returns.
Risk toleranceRisks associated with a plan like equity exposure should be monitored regularly. A limit should be addressed on how much risk a plan can take and an exit strategy if circumstances go out of hand.

Final thoughts

Take a look at the example above. As you will notice, not many retirement structures allow such significant contributions. A 401(k) plan does not even come close.

Cash balance plans are great options for:

  1. Business owners who have consistently high profits.
  2. Professional service companies (physicians, attorneys, consultants, etc.).
  3. Owners who have fallen behind on retirement and are looking to “catch up.”
  4. Owners in high tax brackets looking for tax deferrals. 

If you think a plan may work for you, review your situation with your financial advisor and CPA. Hopefully, a cash balance plan will become a beautiful tool in your retirement arsenal.

Cash Balance Plans for Professional Practices [Tips + Video]

What if you could put an extra $100,000 to $200,00 a year into retirement? Cash balance plans for professional practices could do this for you.

While these retirement structures allow big tax deductible contributions, they can be complex. We’ll discuss what makes these plans so unique.

In this post we will show you how these plans are structured and give you some insight. The goal is to give you some instruction on plan design the related deadlines. Let’s dive in!

Some background

Unlike traditional pensions, the money will be available as a lump sum in retirement, hence the Cash Balance. Another good advantage to the Cash Balance plan is that the management of the funds is typically allowed by the employee, much like a 401k.

Various investment choices, such as mutual funds, may be available. Traditionally, pensions were managed professionally by the employer/third party, and participants were just given a formula for an amount of money or income available at retirement.

Cash Balance Pension plans typically give employees 5% to 8% of their yearly salary as employer contributions. Participants also receive interest in the account and, most of the time can choose other investment options, to potentially increase their savings.

In terms of plan costs, cash balance plans can cost more than 401k’s to set up and maintain. Some costs can range from $1,000 to $3,000 in setup fees alone and then thousands in annual fees for annual administration.

There are limits involved with Cash Balance plans or any defined benefit plans. The limits are more generous than 401k’s and other similar retirement plans. This makes the Cash Balance pension a popular option in later years to help greatly with taxes.

So how do the plans work?

Defined benefit plans are not very common in the private sector. In fact, statistics show that only 4% of workers in the private sector have a defined benefit pension plan. About 14% of private companies have combined defined benefit and contribution plans.

The public sector prefers defined benefit plans, with 88% of employees covered under a defined benefit pension plan. A good reason for this is that the employer contributes to the plan in the private sector and bears the risks associated with overall funding. Accordingly, they may be deemed too risky. But in the public sector, employees can often contribute to their own defined contribution plans.

Defined benefit plans also work well for employers and key employees with high compensation. An annuity is calculated as a percentage of earnings. If the compensation is high, then the retirement benefit is also high. Small employees with small revenues have very few retirement benefits to smile about.

Cash Balance Plans for Professional Practices

However, we have seen increased cash balance plans for professional practices in recent years. The main reason is that small business owner (including sole proprietors and single shareholder S-corps) have realized that the plans have become a great way to secure their retirement. As long as employee contributions can be minimized, significant personal contributions are possible.

With 401K plans, employees will invest personal pre-tax dollars into the market in anticipation of a decent rate of return. But the risk is on them. In contrast, a defined benefit plan has a regular rate of return that the company monitors and the plan actuary.

Business owners can use a plan to maximize their contributions and retain and reward essential employees. It often acts in place of a bonus subject to immediate income tax. Employees may not see the primary benefit (like a bonus), but they tend to be a key ingredient in employee retention.

So what is the employer’s responsibility?

The employer has many responsibilities when it comes to administering plans. The primary responsibility is to invest the plan assets for the benefit of the employees.

If investment returns are lower than anticipated, the company will be forced to make up for the shortfall. To avoid any complications, the company will need to consider three investment issues:

Asset diversityThe allocation of plan assets will significantly impact overall plan funding.
Interest rate assumptionsPlanned and expected interest rates will play a big part in the plan returns. Higher assumed rates might minimize the company’s funding requirements. Conversely, lower rates may require the company to step up funding efforts.
Dealing with plan shortfallsIf expected returns are less than anticipated, the company may have to deal with a shortfall as with any investment. This is not the case with other retirement plans that allow for elective contributions. In some situations, shortfalls can be amortized over future years. But this issue should be discussed with your CPA and third-party administrator.

Cash Balance Plans for Professional Practices [Strategies]

Include your spouse in the plan

Spouses usually provide support in the business, even on a part-time basis. They should, therefore, be on the payroll and are subject to a 15.3% employment tax. Being on the payroll allows them to receive benefits like any other employee.

Therefore, they can make contributions to a 401k and a profit-sharing plan. Thus, a business owner can contribute to a defined benefit plan for their spouse. However, the spouse should be working for the business.

Hire non-qualifying employees

Another good strategy is to hire employees based on their age and working hours. A defined benefit plan requires that an employee should work more than 1,000 hours and be 21 years or more. Part-time employees and those under 21 years old are, therefore, excluded.

An employer should, however, be careful when using this strategy. Young employees, for example, may lack the necessary business experience. Part-time employees might not have the motivation or commitment.

Don’t forget plan entrance date

The entrance date is when employees can enroll once the service conditions and age requirements are fulfilled. Entrance dates can be monthly, quarterly, semi-annual, or annual.

An annual entrance date will be favorable for business owners wishing to keep transient employees off the plan. It is the most restrictive timeline under the defined benefit plan rules.

Consider a higher wage

Business owners with S corporations benefit from defined benefit plans. They can limit payroll taxes through reasonable owner compensation. They can also avoid double taxation subjected to C corporations. 

Contributions to a defined benefit plan depend on age and compensation level. By increasing the W-2 salary, the owner can maximize his contribution. This can also apply to the spouse. However, a high wage translates to higher employment tax and social security contributions.

The social security wage base has limits. Therefore, the 12.4% social security tax cannot exceed this wage. Thus, a business owner can increase wages with minimal taxation increases.

But before doing this, make sure to discuss the reasonable compensation rules with your CPA.

Consider 3 Year Cliff Vesting

Plans can have a 3-year vesting. Cliff vesting is often the favored strategy. It requires participants to be 100% vested after three years of participation. Therefore, no participant is vested until they attain three years of service.

In the case of termination before three years, all the contributions are forfeited. They can then be used to reduce future contributions.

Utilize a life insurance strategy

A defined benefit plan allows for plan assets and future contributions to pay for life insurance premiums for its participants. The life insurance policy will use tax-deductible dollars.

How to structure cash balance plans for professional practices

Here are 5 steps to structuring a plan for your business:

  1. Consider how much you would like to contribute

    If you want to get for example $10,000 to $30,000 into a plan then a 401k might be best. But for contributions in excess of $100,000 a defined benefit plan would be ideal. Have your TPA run an illustration to find out contribution levels for your business.

  2. Examine your expected business profits

    Don’t forget that solo 401k contributions are elective. However, defined benefit plan contributions are not. Take a close look at your business cash flows. If you expect large profits then a defined benefit plan might be a wise choice. If you foresee a slow down or possibly a recession, you may want to consider other options.

  3. Review plan costs and fee structure

    A solo 401k plan is inexpensive to administer. But defined benefit plans are a little more expensive. The higher fees can make a lot of sense if you are contributing significant amounts. Fee structures can vary from administrator to administrator and prices are much higher for larger plans with many employees. Just consider the cost and benefit of each plan.

  4. Discuss with your financial advisor or tax professional

    Do you have a close relationship with a financial planner or CPA? Discuss the issue and consider their recommendations. A tax professional is in a great situation to review your tax rate and offer suggestions. Remember that most financial professionals don’t usually understand how the plans are structured. Cash balance plans for professional practices can be complex, so you will need to allow time to make sure all parties are educated.

  5. Don’t lose sight of the deadline

    Many people forget that the deadline to establish a calendar year plan is before the tax return is filed. This also included extension periods. But make sure not to wait until the deadline because you also need to get investment accounts set up.

Defined Benefit Plan Rules & Requirements [Tips + IRS Pitfalls]

By now you probably know that defined benefit plans are one of the best available retirement structures. Unfortunately, most people don’t know the defined benefit plan rules and requirements or how to structure the plans for maximum benefit.

Accumulating $1 million in retirement is tough. So, before we dive into the strategies, let’s take a look at some of the basics. This is critical to understanding how a plan can work for your business.

What is a defined benefit plan?

Define benefit plans are retirement accounts that promise a predefined retirement income to their plan participants. The monthly payouts depend on several factors, such as age, employment history, and income level of the plan participant.

It is important to note that the payment method might vary from one company to another. Some organizations follow a conventional annuity structure, where their employees receive monthly benefits. Others might offer lump sum payment at the time of retirement of the employee.

You can think of it as a 401k on steroids. It will offer substantially higher contributions, sometime double or triple the amount depending on age and income.

However, they are more expensive and are administratively more complex. But if you are looking for large tax deductible contributions this might be your best bet.

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o why should you consider a defined benefit plan? Simply put – no other retirement plan structure allows business owners to get as much money into a plan and still get a tax deduction.

You can’t get this with an IRA, 401k or a SEP. While there can be some disadvantages, they are the best retirement vehicle for high-income business owners.

How do defined benefit plan rules differ from defined contribution plans?

One of the common confusions among plan participants is about the difference between defined benefit plans and defined contribution plans. Unlike defined benefit plans, employers have no obligations to assume investment risks under defined contribution plans.

In defined contribution plans, employees are responsible for both contributing as well as tracking their investments, although most of the employers offer a small matching contribution, up to 3% of annual salary, to these plans.

rules and requirements

401k plans are the most common type of defined contribution plans available in the private sector.

Defined benefit plan rules and requirements

Defined benefit plans are one of the faster growing retirement structures. This is a result of high contribution levels and significant tax deductions.

Most of the requirements revolve around eligibility and funding levels. For example, take a look at the following three rules:

  1. Include less than half your employees – There is no requirement that you have to cover all your employees. In fact, IRS only requires a 40% coverage. IRS section 401(a)(26) stipulates 2-part tests as follows:
  2. Employees receiving a benefit under a plan should be a lesser of 50 people or 40%; and,
  3. “Meaningful” contributions to be made towards the plan.

Those are a few of the basic plan rules that must be followed. Once we have determined employees and eligibility, we can take a closer look at the calculation.

The good news is that the deadline has been extended. You now have up to the date your tax return is filed (including extensions) to set up and fund a plan. But don’t cut it too close. You will need a few weeks to get the plan established and the account opened and funded. So make sure you do it timely.

Understanding minimum benefit rules

One of the IRS requirements for a valid plan is the “meaningful benefit” to the participant. IRS defines this as an accrued benefit of at least ½% of pay.

While IRS does not specify ½% defined benefit credit itself, it should be large enough to generate a ½% retirement benefit. This will translate to about 2-3% of the current pay depending on employee salary and age. For example, an employee with a $40,000 annual salary has a benefit of about $800 to $1,200.

Age-weighted contributions mean that older employees have larger contribution while younger employees contribute less. The plan cannot benefit small groups of employees. This can invalidate the plan.

Due to defined benefit plan age-weighted capacity, a business owner can eliminate some older employees and include some young ones. This can result in a lower overall employee contribution while still being a meaningful benefit.

Who is eligible for a defined benefit plan?

Who is eligible? You can typically exclude employees who are under age 21 and who work less than 1,000 hours in a year. Make sure that you coordinate with your accountant and administrator.

An actuary will determine annual contributions based on several factors, including:

  • retirement age;
  • employee’s life expectancy;
  • annual retirement benefit amount;
  • interest rates; and
  • potential employee turnover.

Once the employee attributes are identified, the company has the option of selecting a formula. For example, any of the following formulas may be used:

  • flat dollar amount or unit benefit;
  • percentage unit benefit; and
  • flat percentage of pay.

A flat dollar amount uses a flat annual amount, for example $1,500. Benefits can be calculated as a flat percentage of pay or an average of salary.

For example, an employee that worked for 25 years will receive 50% of his or her average earnings (on an annual basis) during the three consecutive years of employment with the highest earnings.

A flat amount unit formula uses a flat amount with each unit of service, normally with each year. For example, an employee with 50 units of service would receive a benefit equal to 50 times the unit amount at retirement.

The most popular defined benefit formula is the percentage unit benefit. It considers both the level of compensation and years of employee service. If you want to run your numbers take a look at our plan calculator.

What is a third-party administrator (TPA)?

There are many different rules applicable to defined benefit plans. But the most significant rules relate to non-discrimination (including eligible employees), annual contribution limits, and sign off by an actuary. For these reasons, make sure you have an administrator (TPA) that understands the complexity of these plans including the limitations.

Let’s dig a little deeper into what TPAs do for defined benefit plans. TPAs will for example:

  • Provide consultation regarding the design of the plan, taking into account the financial goals of the employer as well as employees;
  • Create a blueprint example for the operational activities throughout the plan;
  • Draft plan documents;
  • Work with an actuary for compliance and risk assessment;
  • Design contribution and distribution policies of the plan suiting you as well as critical employees;
  • Ensure that the plan complies with the rulings mentioned under ERISA;
  • Provide tax filing services (5500).

Need for specialization

Some employers might require specific services for their retirement plans. For instance, a cash balance plan involves accurate, timely compliance filings, requiring particular legal skills. A potential candidate should know his/her way around your specific requirements.

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Start by providing critical information to the TPA, such as the size of your business, number of employees, age of employers and key employees, and financial goals associated with the plan.

After sharing these details, find out whether the TPA:

  • Understands the administration responsibilities required by the Department of Labor (DOL) and IRS, such as plan design or customizations, installation of the plan, drafting requirements, enrollment procedure, compliance testing, required government reporting, and the need for actuarial services, etc.
  • Can handle plan administration along with additional services such as financial advisory or payroll management. Ideally, choosing a TPA that offers specialized services for specific types of defined benefit plans is a better choice in most cases.

Final thoughts

These plans can be challenging to understand. Hopefully, you have learned a little about how these plans are structured and know more about the defined benefit plan rules.

So what is a defined benefit plan? If you’re guilty of running short on your retirement savings goal, a defined benefits plan is an excellent option to start with. We’ve created this comprehensive guide to help you get a head start in your retirement preparations.

So there you have it. We have covered the rules and tried to make them as simple as possible. If you still have questions, please give us a call and we can answer any remaining questions you may have.

Defined Benefit Plan Small Business Options [Strategies + Pitfalls]

Defined benefit plans remain a little-known tax secret. They offer large tax-deductible contributions. But how much do you know about the defined benefit plan small business options?

There are many excellent strategies that you can use to maximize these plans. But by nature, these plans get a little complex.

In this article, we will show you how to structure these plans and offer you a few tips on how to implement. You just might see why we love these plans so much. Let’s jump in!

What are the Tax Benefits?

Tax policies encourage retirement savings. Favorable tax treatment on contributions, investment income, and benefits related to income accumulated for retirement.

Contributions by an employer towards a pension plan are deductible in corporate income tax computation. Employees also enjoy tax deferral on personal income until when they receive distributions from their plans. Tax deductions have improved retirement savings for many families in the U.S.

The plans specify that for a plan to qualify for tax deductions, it must meet minimum standards. These standards relate to participation, vesting, and non-discrimination against low-paid employees.

However, the IRS prescribes maximum tax deductible contributions. Contribution limits will vary depending on the type of plan, availability of more than one plan for employees, and whether the plan is top-heavy, meaning that owners and key employees benefit more from the plan.

Defined Benefit Plan Small Business Strategies

Annual contributions are generally driven by age and compensation. But the good news is that there is some flexibility.

Usually these plans are structured to allow minimum and maximum contributions that can be scaled up or down. All contributions are qualified and allow for an immediate tax deduction.

Employers have to ensure that the IRS approves of plan actions. The plan must comply with all plan requirements and IRS testing.

So the key is to play within the rules, but still maximize owner contributions. Let’s take a look at some of the strategies and an example.

Combine with Other Retirement Plans (like a 401k)

An advantage with a defined benefit plan is the combination of other retirement vehicles. In many cases, this is a 401k profit sharing plan.

The 401k plan will provide an extra contribution of $19,500 as an employee deferral ($26,000 if above 50 years old). It also can provide a 25% contribution from a profit sharing plan.

401k plans can be safe harbor plans. The employer makes a safe harbor plan contribution. Profit sharing contributions by an employer for the employee usually range from 5% to 7.5%.

Safe harbor plan make a 3% non-elective contribution. This can subtracted from the profit sharing contribution in the 5% to 7.5% range.

Consider Funding for Past Service

At this point we understand what a great tax planning tool these plans provide. But it gets even better.

Plans can be structured so that they provide for employee “past services.” You can go back from one to five years and examine compensation paid to employees. In the year of set-up, you would then make a one-time contribution for this past service. It’s almost like a “catch-up” contribution.

A small business owner can make maximum contributions that will exceed the targeted contribution in that year. This will enable the small business owner to get a tax deduction in a year when income will be high.

Let me show you a great example of a past service adjustment we did for a client. The client was 31 years old and had W2 income of $50k. Based on actuarial tables, he could only get approximately $15k into the plan for the current year.

But once we examined his W2s for the last 5 years, we were able to make a past service adjustment that allowed him to get another $105k into the plan. With only a W2 of $50k, he was able to get $120k into a plan. This is just one example. Not that bad.

But there are a couple things to consider. First, you have to include all employees in the plan. This can get expensive if there are a lot of employees. Second, providing for past service will essentially pull from future years. So it will result in high funding in year one and lower funding levels in subsequent years.

Third-Party Administrators (TPAs)

A third-party administrator (TPA) is an organization that offers administrative services or pension plans. Managing the administrative tasks is a challenge for employers. Accordingly, they usually contract a third-party administrator to handle much of the hefty administrative work. This allows the employer to concentrate on the remaining investment tasks.

Since not every employer is a financial expert, having a professional service provider manage retirement accounts is an ideal strategy; that’s where third party administrators or TPAs come in.

A TPA is a professional service provider (company or licensed individual) that manages retirement plans for companies. TPAs are responsible for taking care of the day-to-day management, administration activities, compliance, and filing returns on time.

How to Choose the Right TPA?

Sophistication and understanding of the regulations surrounding defined benefit plans aren’t the only qualities a TPA must possess. Ideally, your TPA should have prior experience in managing similar plans, be able to offer specialization as per your needs, offer competitive products, and communicate essential changes, options to the small business as well as the employees.

Experience of TPA

Every organization has specific, different financial goals and obligations towards their employees. A TPA should be able to analyze these goals and offer a suitable plan design, customizations for your business.

  • Find out if the TPA has prior experience in providing similar services. Most of the TPAs won’t mind sharing the contact details of their previous clients. Speak with these companies and find out how the TPA helped them throughout the process.
  • Make sure to keep your financial advisor in the loop, if not present in these meetings. Your financial advisor can help you understand critical terminology, intricacies of the plan design, and associated expenses.

Let’s Look at an Example

Peter is a small business owner who is taxed as a sole proprietor. He is age 60 and has no W-2 employees. He developed a software program for a company and was paid $615,000. Normally, Peter makes about $150,000 every year where he contributes about $40,000 annually to a 401k plan.

Because of the huge income made that year, Peter wants to set up a defined benefit plan to get an extra $200,000 plus into retirement for the current year. In subsequent years, he would want to make lower contributions. Peter has chosen to combine his 401k profit sharing plan with a defined benefit plan.

Peter makes the following contributions:

  • Defined benefit plan = $170,000
  • 401k deferral = $19,000
  • 401k profit sharing = $18,000
  • Total contribution = $207,000

Peter, therefore, got a huge tax deduction for his windfall income year and still can maintain lower contributions for future years. Peter can make smaller contributions to the defined benefit plan and chose to not make any contributions to the 401k or profit sharing plans since they are elective.

Custom design plan structurePermanent plan requirement
Allowable for any small businessHigher administrative costs
Qualify for full tax deductionMust contribute for employees
Contributions over $100kMandatory annual contributions

Bottom Line

America’s retirement problem is no secret. A recent survey from Bankrate finds that 1 in 5 Americans save nothing for retirement or other financial goals, whereas another 20% save less than 5% of their annual income. Only 16% of Americans are saving more than 15% of their yearly income.

Saving for retirement isn’t complicated. All one must do is to contribute consistently throughout his employment. The key to having sufficient retirement savings is to start early and stay disciplined. Considering the financial challenges retirees are facing at present, defined benefit plan small business options could be a blessing in disguise.