How much does your CPA or financial advisor know about the defined benefit plan tax deduction limit? Probably not much.
It’s not because they are incompetent. It’s just because most professionals don’t practice tax planning.
When most people think of a defined benefit plan, they think of a large company pension. But this is simply not the case. Defined benefit plans can be successfully used for small businesses as well.
This is why we call them one of the best kept tax secrets. Is a defined benefit plan tax deferred? Let’s get into some of the specifics.
Table of contents
- How are defined benefit plans taxed?
- Pass-through businesses and the 20% tax deduction
- Tax Benefit & Deduction Limits
- Good Tax Deferred Candidates
- Defined Benefit Plan Tax Deduction Limit
- Is a defined benefit plan tax deferred?
- Are contributions tax deductible?
- Are contributions to defined benefit plans tax deductible?
How are defined benefit plans taxed?
Defined benefit plans are traditionally favored by business owners with high incomes, like physicians and attorneys. If a business owner and spouse (who works in the business) contribute to a plan, they could enjoy up to $600,000 in tax deductions and retirement contributions. This becomes especially important considering the new tax laws passed in 2017 (more about this later).
Contribution limits increase as employees approach retirement. This is possible due to high contributions made towards the plan. Another defined benefit plan advantage is that they can be combined with other plans like a 401(k) and profit-sharing plan that can maximize contributions and tax deductions.
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Employees may also prefer a defined benefit plan. Employers (or plan sponsors) do all the tasks. This includes the obligation to make contributions, assuming investment risks, and completing all plan responsibilities. The sponsor can, however, appoint a third-party administrator (TPA) to help with administrative responsibilities while it concentrates on plan investments.
Pass-through businesses and the 20% tax deduction
Pass-through business owners (including partners, S-corporations and sole proprietors) have a lot to smile about with tax reform. The 2017 tax reform offers significant tax savings to qualified business owners. Pass-through businesses can now take a 20% deduction from qualified business income.
However, the rule will not apply equally to all business owners. It restricts certain service businesses like consultants, accountants, physicians or attorneys if their taxable income is over a specified limit.
If over the threshold, they may pursue additional tax strategies to lower their taxable income. This is where the deduction can really help.
Professional service business owners often realize that setting up a defined benefit plan is one of the best ways to remain below the specified threshold. The threshold is taxable income of $157,500 for single filers and $315,500 for married filers.
The 20% deduction limit is gradually phased-out for personal service owners until a complete phase out of $207,500 for individual filers and $100,000 for married filers.
Tax Benefit & Deduction Limits
Contributions under a defined benefit plan can be as high as $300,000, depending on age and income. In contrast, 401(k) plans allow a contribution up to $57,000, plus an extra $6,500 for individuals 50 years and older. Combining a defined benefit plan with a 401(k) and profit-sharing plan can result in even larger tax deductible contributions.
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A sole proprietor with a defined benefit plan can even benefit under the 20% tax deduction. Partners and business owners in an S-corporation, therefore, have to split the tax deduction benefit between the owners. Based on non-discrimination testing, business owners will typically have to contribute 5% to 7 1/2% of pay for other company employees.
Defined benefit plans can be combined with other strategies including charitable contributions to further reduce business taxable income. Accordingly, business owners should seek to combine a variety of strategies to make sure they qualify for the 20% tax deduction.
Good Tax Deferred Candidates
Defined benefit rules require high business income or high employment income. Due to restrictions and limits applied to the 20% tax deduction, high contributions under a defined benefit pension can be a solution. The following may, therefore, benefit the most from a defined benefit plan tax deduction:
- Physicians, lawyers, CPAs, financial planners, investment advisors, consultants and engineers;
- Business owners who have profitable businesses and sustainable, consistent income;
- Business owners over the age of 50 who may have minimal retirement funds;
- Owners who would like to include life insurance;
- Companies who desire to hire and retain critical employees; and
- Other high-income professionals who desire significant tax deferred savings.
Defined benefit plans are a highly effective tool for tax planning. However, make sure the business owner is educated on the pros and cons of the plans.
In addition, adequate cash flow should be available to fund plan contributions up to the limit. A third-party administrator should be used to ensure that administrative tasks are accomplished.
Defined Benefit Plan Tax Deduction Limit
So what is the deduction limit? The IRS states that the maximum amount of contributions that a company can deduct is 150% of the current liability for a single employer plan. The limit is determined as of the plan valuation date and is adjusted for interest through the earlier of the plan year-end or the end of the employer’s taxable year.
With a defined benefit plan with 100 or fewer participants, the current unfunded liability for deduction purposes typically would not include a liability resulting from an amendment made within the past two years that provides more significant benefits to any highly compensated employee (“HCE”).
Combined or Combo Plan Deduction Limit
The IRS recently relaxed the deduction limitation on contributions by an employer with both a defined benefit plan and a 401(k) plan or other defined contribution plan covering at least one of the same company employees. Typically, the contribution deduction for combined plans is limited to 25% of compensation or the contribution required to hit the minimum funding requirement of the defined benefit plan (but not lower than its current unfunded liability).
When determining this combined plan limit, the IRS excludes multiemployer plans from consideration. Thus, under the new rule, separate deduction limits for contributions to defined contribution plans and defined benefit plans apply if either plan is a multiemployer plan.
The IRS has further relaxed the combined plan limit by providing that it only applies to the extent company contributions exceed 6% of compensation. When the contribution to the defined contribution plan exceeds the 6% threshold, the deduction limit will apply to the total company contributions to both the defined benefit plan and the defined contribution plan, less than 6% of the compensation of the participants in the defined contribution plan.
Is a defined benefit plan tax deferred?
Yes, a defined benefit plan is typically tax-deferred, meaning that the contributions made to the plan, as well as the investment gains earned on those contributions, are not taxed until they are withdrawn from the plan. This tax-deferral can provide a significant advantage for plan participants, as it allows their retirement savings to grow more quickly due to the compounding of investment returns over time.
In addition, the contributions made to a defined benefit plan may be tax-deductible for the employer, which can provide a valuable tax benefit for the company. However, it is important to note that there are limits on the amount of contributions that can be made to a defined benefit plan each year, and these limits may change from year to year based on IRS rules and regulations.
When plan participants begin to receive retirement benefits from a defined benefit plan, those benefits are generally subject to income tax at the participant’s ordinary income tax rate. However, there are certain exceptions and rules that may apply depending on the specific circumstances of the participant and the plan. It is important to consult with a tax professional or financial advisor for guidance on the tax implications of participating in a defined benefit plan.
The IRS has clarified that elective deferrals made by the plan participants are excluded when calculating company contributions to a defined contribution plan for purposes of the combined plan limit. Still, matching or nonelective contributions made by the employer are included.
The IRS provides unexpected guidance regarding applying the combined plan limit when employer contributions to the defined contribution plan do not exceed the 6% threshold. The tax deduction limit will not apply to any company contributions to a 401(k) plan or other defined contribution plan.
Are contributions tax deductible?
How to maximize defined benefit plan tax benefits:
- Calculate marginal federal tax rate
Take a look at your prior year tax return and analyze your current year tax liability with your CPA. Consideration should be made to both your federal and state tax rate. If your rate is increasing, a plan will make more sense to set up. Ensure any proposed federal and state tax proposals are considered.
- Consider your funding range
In the first year we often establish a flat dollar amount. But this can also be a variable contribution. Most clients will select an ongoing variable amount that will provide a wide enough range. This is because situations change and clients want funding flexibility as opposed to flat dollar contributions. This way they can increase tax deferred contributions in years with high taxable income.
- Review employee census
While many plans are for solo business owners (no employees). But don’t forget that you will have to make plan contributions for any qualifying employees. Our goal is always to get at least 85% to 90% of the overall contribution allocated to the owner. But sometimes this can be difficult if there are many older employees.
- Examine your cash position
Even though your tax situation may dictate a large plan contribution, you might not have the cash position. You might be thinking of purchasing equipment or looking to retain cash in the business. The good news is that you can fund the plan up to the date you file your business tax return (including any extension). This will bring you some funding flexibility.
- Execute funding goal
Once you are comfortable with your funding range, review with your tax advisor and administrator. Remember that your contributions are required by the date you file your tax return. Don’t forget to make the contribution and communicate the funding to your CPA.
Are contributions to defined benefit plans tax deductible?
In the table below, I outline several of the critical tax benefits of defined benefit plans. The goal is to spell out some of the reasons that business owners should consider setting up these plans. Take a look:
|Tax Deductible Funding ✅||Permanent Plan Structure|
|Tax Deferred Investment Growth ✅||Not Good with Many Employees|
|Qualify for QBID (Section 199)||High Fee Structure|
|Flexible Funding Range||Conservative Investment Limit|
The goal of every retirement plan is to maximize retirement savings while saving money on taxes. Defined benefit plans are no different. Your defined benefit plan tax deduction will vary based on your tax bracket and contribution size.
Is a defined benefit plan tax deferred? Section 401(a) of the Internal Revenue Code specifies defined benefit pension plans as qualified plans. Accordingly, S-corporations, sole proprietors, and C-corporations receive a tax deduction for contributions made to the pension plan.