Thinking about getting over $75,000 into a retirement plan? Well a 401k won’t cut it so you may have to turn to a defined benefit plan.
Even though you know the term, you probably don’t know much about the plans themselves or how they work. We’ll try to break it down for you.
Table of contents
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.
|Age||DB Plan||401k Plan|
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.
Final Thoughts on DB Plans
So there you have it. You can see why 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!