What is the maximum amount I can contribute to my defined benefit plan?
This question gets asked all the time. Defined benefit plan contribution limits can be challenging. That’s why I decided to break it down.
Before we dive into the details, take a look at the table below. I have spelled out the benefits and also given you a few links to get some add’l info.
These plans are great for small and large business owners who are looking for large, tax-deductible contributions. Let’s jump into the details.
Table of contents
So what are the contribution limits?
Defined benefit plans have become popular for the self-employed. The plans are set up to provide a predetermined retirement benefit to employees (or their beneficiaries). But what are the defined benefit limits?
At the end of the day, there is no set maximum defined benefit plan contribution. Instead, the final benefit payment at retirement is limited. This is commonly referred to as the 415 limits.
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Based on the limits, a participating employee with ten years in a plan may receive a maximum annual benefit amount of $235,000. This would start at age 62.
The IRS will place a compensation maximum used in the benefit calculation. For the year 2021, the maximum compensation is $290,000. The IRS annually indexes these compensation and benefit limits.
This is either in the form of a certain lump sum dollar amount or a specific percentage of compensation. In contrast, a defined contribution plan is typically employee funded. Think 401k, 403b, and IRA’s.
Employer contributions to a defined benefit plan are very complex to determine and require the work of an actuary. The assets of the plan are held in a pool, rather than individual accounts, and as a result, the employees have no voice in investment decisions.
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What is the maximum contribution I can make?
Once established, the employer must continue to fund the plan, even if the company has no profits in a given year. Since the employer makes a specific promise to pay a certain sum in the future, it is the employer who assumes the risk of fluctuations in the value of the investment pool.
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Before 401k’s became popular in the early 1990s, many companies offered a traditional pension. Typically an employee worked a set amount of years, for a certain amount of income at retirement; there were no bells and whistles and no options other than the life annuity at retirement.
What is the annual benefit limit?
Obviously as these became popular, the IRS imposed limits and regulations on defined benefit plans. They typically adjust it each year due to cost of living, much like IRA and 401k contribution limits.
Contributions to a defined benefit plan are based on actuarial assumptions and computations. These calculations will be determined up front.
So the contributions are based on the required amount needed to provide benefits under 415. This is why plans must have an actuary review and certify the plans annually. The compensation amount of $225,000 is not entirely accurate. The annual defined benefit limits may not exceed the lesser of:
- 100% of the employee’s compensation averaged for the highest 3 consecutive years; or
- $225,000 (as discussed)
How can I maximize my contributions?
There is no maximum dollar amount per se. The contribution amount must be enough to satisfy an annual benefit paid out in the future. This will not be able to exceed 100% of the employees average compensation over 3 consecutive years.
The employee may have a W2 that is higher than the limitation, but the actuary will only use the maximum contribution.
Annual contributions under a defined benefit plan can be upwards of $300,000. This is especially true for employees getting close to retirement age.
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But to truly maximize contributions, the plans can be combined with a 401k plan. With a “combo” plan, the actuary will still perform cross-testing on both plans to make sure they are in compliance.
The company has the ultimate responsibility to invest the plan assets for the benefit of the employees. If the investment does not generate the required return, the business owner may be forced to make additional contributions to essentially “catch-up” the account balance. That is why it is critical that the company makes two important investment decisions:
- Proper asset allocation – this has a significant impact on investment returns. If the assumed interest rate is high there could be large shortfalls if anticipated returns are not met.
- Addressing plan shortfalls – if the plan assets do not result in the expected returns, elective 401(k) contributions may be paused to free up funds to finance the required defined benefit plan contributions. Certain shortfalls can also be amortized based on established IRS criteria.
How much can I contribute?
The defined benefit limts will be significantly higher than those of a 401k plan. That is unless a business owner is young (under 30 years old). The contribution difference grows higher as age increases.
This enables business owners to put away large amounts into retirement and build tax-deferred accounts. That is why defined benefit plans are great for business owners who have higher-than-average compensations. It may be the best financial decision you can make for your future.
It is important to understand all your options when determining which type of retirement plans you will offer in your company or practice. We can help you put together a solid IRS approved plan to your advantage.