What is a DB Plan? IRS Rules + Formula & Benefit Guide [Video]


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You may have heard of the benefits of a DB plan. But what is a DB plan and how does it work? Also, do you really understand the rules and the formula?

Before establishing a DB plan, you must understand how to structure one and carefully analyze the pitfalls and benefits.

In this post, we will cover the plan basics. We have a couple videos that will explain the cost and eligibility requirements. Let’s dive in!

What is a DB Plan?

The term DB plan is just short for defined benefit plan. Defined benefit plans promise a specific benefit after retirement for each of the employees. The term “defined” is used because the plan uses a benefit formula that is known in advance.

A DB plan works a little differently than your typical 401k plan. With a 401k plan the IRS limits the amount that you can put in up front. Currently this limit is $57,000 annually.

But a DB plan allows for much larger contributions. This is because the plans are looking to provide a specific benefit at retirement. As such, you can make larger contributions today to reach your retirement goal down the road.

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You can think of it like a turbo charged 401k plan. Annual retirement contributions are often greater than $100,000 and we have many clients who contribute over $300,000 annually. The plans are more complex to administer, but are great for high income business owners.

How large can the contributions be?

We have discussed the fact that DB plans allow for much larger contributions compared to 401k plans. This is true.

But the size differential widens as people get older. The reason is that the closer they get to retirement, the more the plan will allow to reach that end retirement goal.

This is illustrated in the table below. The table compares the maximum contribution for both a DB plan and a 401k. Look at how the gap widens as people age.

What are the pros and cons?

DB plans are what is called a “qualified” plan. This basically means they qualify for a tax deduction or tax deferral. When you contribute to the plan you get an immediate tax deduction, but are subject to taxation when you take the funds out at retirement. Let’s point out a few other benefits:

  • Plans are not subject to the $57,000 contribution limits that come with defined contribution plans (like a 401k).
  • Qualified plans are generally afforded lawsuit and bankruptcy protection.
  • They work for all types of entities. This includes sole proprietors, S-corps, C-corps and partnerships.
  • They can be combined with other retirement plans like a 401k, profit sharing plan or even a traditional IRA.
  • Solo DB plans can utilize a a Mega Backdoor Roth to supercharge contributions.
  • They allow what is called portability. When an employee leaves a company, they are allowed to take their vested account balance to another retirement plan or even roll it into an IRA.
  • Any contributions become tax deductible.

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But there are a few other things that should be considered before you set up a plan:

  • The plans are actually “permanent.” This really means that you have to have them open for at least several years. But you are allowed to terminate the plan for reasonable cause.
  • Contributions are typically not elective like 401ks or other defined contribution plans.
  • An actuary is required to review and certify the plan every year. This is to make sure the funding is able to pay future retirement payments.
  • They are more costly to set up and administer. Typical plans will run at least $2,000 to annually administer.
  • The plans often have restrictions on any lump sum payment.

What if I have employees?

There is no doubt that these plans work best for solo business owners or professionals. If you have eligible employees you will be required to make a contribution for them. But there are ways to limit your exposure.

As a guide, the employer can exclude part time employees and certain other employees, but will need to make a contribution of approximately 5 to 7% for remaining employees in order to pass the rules.

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Employee contributions are usually not that significant at the end of the day. Our goal is to get 85% to 90% of the contributions for the business owner. This is not always possible if the owner has substantial high income and older employees. But that is at least the goal.

So how does compliance work?

IRS assumes supervisory activities of pension plans. The rules and regulations have helped avoid abuse of privileges granted to pension plans.

One very important rule is “non-discrimination.” It verifies that a plan does not favor highly compensated employees. The regulations have favored DB plans and have encouraged employers and employees to increase their retirement savings. However, the IRS and the Department of Labor have strict compliance standards.

The investments will grow tax-deferred once the company has contributed to the plan. Benefits from defined benefit pension plans are received at retirement or earlier and are subject to federal and state personal income taxation.

Rules, formula, and benefits

The employer can exclude part-time employees and certain other employees but must contribute approximately 5 to 7% for the remaining employees to pass the rules. Employees receive annual contributions from the employer.

The plan gets pre-determined additional contributions on the employer’s part based on the amount contributed as a percentage of the employee’s salary. So the requirements aren’t that difficult.

What about IRS rules?

Under defined benefit plan rules, employees or participants receive vested accrued benefits earned to date. The benefits should be received no later than the 60th day after the plan year’s end when they have been employed for ten years or decide to leave a job.

When an employee leaves the job, the benefits earned to date are frozen and held in trust until retirement age if they don’t choose to take a lump sum or rollover to another pension plan.

Taxes written on hanging tags. What is a DB plan

Benefits in a defined benefit plan are distributed through life annuities. The participant receives monthly, quarterly, or annual benefit payments for the rest of their lives. One begins receiving the benefit not later than April 1 of the next calendar year following the year of retirement or following the year an employee attains seventy and a half years, whichever is later.

A participant’s spouse can receive a 50% benefit because a defined benefit plan allows for joint distributions. Once employers and employees have contributed to a defined benefit plan, they invest assets to grow their funds and the earnings from these investments are not taxed.

Benefits from a defined benefit pension plan are received at retirement or earlier and are subject to federal and state personal income taxation. A participant also recovers the amounts that have previously been taxed.

How to Set Up a DB Plan

Here are 5 steps to follow when setting up a DB plan:

  1. Determine how much you want to fund in the current year

    Maybe you had a large windfall in the current year so maxing out the plan might make sense. Even if it limits future contributions. Plans can be “front loaded” by including a prior service opening credit. But remember that every dollar contributed today is one dollar less that you can contribute in the future.

  2. Consider future funding levels

    You might choose to stay well below the limit because you anticipate being in a higher tax bracket in future years and you want to make sure that you do not overfund. As such, you could consider straight line contributions or simply fund at the targeted level or in the middle of the range.

  3. Have a TPA run an illustration

    You want an illustration completed that will show you the current year funding and confirm your cash requirement. Most administrators can run multiple scenarios based on different compensation levels and funding goals. They can also be run for larger plans with employees. The goal is a contribution of at least 85% of the contribution going to the owner.

  4. Consider a 401k combo

    If the DB contribution is limited, you can consider the combining the plan with a 401k to improve funding levels. In fact, over 90% of our plans are combo designed and tested. The business owner is then able to get a larger contribution with minimal additional administrative fees.

  5. Make sure you don’t exceed the defined benefit limits

    Your TPA can work with you to make sure that you do not exceed the legal limit. Benefits in a DB plan are distributed through life annuities. A participant receives monthly, quarterly, or annual benefit payments for the rest of their lives. A participant’s spouse can receive a 50% benefit because a DB plan allows for joint distributions.

What about the formula?

Each participating employee has a “hypothetical” account balance. In most instances, the account balance begins at zero in the first year. At that point, pay credits and interest credits are added to the hypothetical account balance.

Pay credits are typically stated as a percentage of pay. But they can also be a flat dollar amount. This “credit” is added to the account annually. But it’s important to note that the sum of hypothetical employee accounts will not equal the investment account balance.

Interest credits are also added to the account balance. The interest crediting rate is specified in the plan document. The interest crediting rate can be a fixed rate or variable. A variable rate is tied to an index, such as a Treasury bill, Treasury note rate, or the consumer price index. 

If desired, the interest credit can be tied to the actual plan investment or market return. However, this can create more volatile results and contribution amounts.

Benefits & FeaturesDownsides
Qualified Asset ProtectionPermanent Structure
Min/Target/Max Funding RangeHigher Plan Cost
Large, Tax Deductible ContributionsRequired Actuary Review
Custom Tailored DesignComplex Administration

What about investments?

Defined benefit plans are typically invested in the stock and bond market, like a 401(k) plan, and managed professionally by a sponsored investment firm. The investments are actively managed and are not chosen by each employee.

An actively managed account is an investment account regularly managed by an investment professional, based on the client’s (in this case, the employer) risk tolerance and funding goals.

But if the plan’s investment returns are less than the guaranteed rate, the employer will need to increase future contributions. This difference is generally spread out over several years. The plan sponsor and trustee have various investment options to achieve the interest credit rate.

Once your plan is set up, you must use an investment platform. Here is some information regarding the custodians and advisors that we work with.

  • The selection of investments for participant-directed 401(k) plans requires that the officers or committee members answer the following questions:
  • Is each investment option prudent and suitable for the participants?
  • Do the funds, in total, constitute a diversity of investment options?
  • Is the investment package suitable for the abilities of the particular workforce–or, if not, can it be made so through offering investment education or advice to the participants?
  • Fiduciaries must monitor the funds and remove any funds that don’t perform well. Some investment providers (such as insurance companies, mutual fund companies, and banks) help fiduciaries by giving them performance, expense, benchmarks, and other information and removing underperforming funds from their investment packages.
  • Other advisors, such as investment consultants, can help the fiduciaries evaluate the participants’ investments.

Final Thoughts on DB Plans

So what is a DB Plan? As you can see, DB plans are one of the best tax planning and retirement structuring tools in the market. No other plans allow self-employed people to make such substantial tax deferred contributions.

But you don’t have to take my word for it. Just submit a request below and we will run you a free illustration so you can see for yourself. You may have just uncovered an excellent retirement tool!

Paul Sundin

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