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.
These plans are great for small and large business owners who are looking for large, tax-deductible contributions. Let’s jump into the details.
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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 $245,000. This would start at age 62.
The IRS will place a compensation maximum used in the benefit calculation. For the year 2022, the maximum compensation is $305,000. 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.
|Age||Maximum Annual Contribution|
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)
|DB Plan Advantages||DB Plan Disadvantages|
|Eligible for QDI deduction under Section 199||Mandatory contributions|
|Flexible min/max/target range||Higher administrative costs|
|$100k plus tax deductions||Conservative investments|
|Tax-deferred growth||Permanent plan structure|
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.
Prior service adjustments
There are several ways you can get higher contribution levels. One such way is to include a prior service or previous service opening credit in year one.
This essentially allows the company to bake a contribution for employees who worked in prior years. as a general rule. You can get an additional 50% of the normal contribution limit based on a current pay credit. This allows a business owner with substantial net income in a current year to make a significant contribution.
But remember that a substantial contribution or frontloading a plan with prior service will help tremendously in year one, but it will tend to reduce contributions in future years.
Remember that defined benefit. Plans are looking to target a benefit amount at the con of retirement. So every dollar contributed today is one less dollar that can be contributed in the future.
Defined benefit plan contribution limits
In addition to adding prior service, there are other options if you want to make more significant contributions. For example, the IRS typically allows a plan to accrue up to 150% of the accrued benefit. This allows the plan or company to make larger contributions above the individual employee benefits. This essentially allows the company to pre-fund or target a larger contribution in a year in which income was higher.
But funding adds up to 150% of the accrued benefit and will reduce contributions in the future. So make sure you consider it in a year with substantial net income.
These plans are age, waited in compensation based. So the older you are, and the more money you make, the higher your contributions will be.
Defined benefit plans, though, do not have a contribution limit per se. They are driven by the 415 limits, which are the same limits that define contribution plan funding.
But defined benefit plans provide funding ranges. This includes a minimum, maximum, and target funding level. The target funding level is essentially a straight-line contribution That will directly lead to the accrued benefit at retirement.
Take a look at defined benefit plan contributions by age in the table below:
|Contribution Averages by Age||Contribution Limits by Age|
|Age 30 = $80,000||Age 30 = $120,000|
|Age 40 = $120,000||Age 40 = $165,000|
|Age 50 = $185,000||Age 50 = $240,000|
|Age 60 = $240,000||Age 60 = $345,000|
But clients have questions. What professions or industries make the most sense for defined benefit plans? Does a plan make sense for my business?
The truth is that many companies and professionals are ideal candidates. The following are great candidates for defined benefit plans:
- Businesses with consistent high profits (historically and forward-looking)
- Professional service companies like attorneys, physicians, engineers, CPAs, etc.)
- Companies who desire to improve morale and employee retention
- Owners trying to “catch up” on retirement savings
- Owners looking to maximize tax deductions
A defined benefit plan doesn’t require high profits to be effective. But it certainly helps. It can be more challenging if your business is cyclical in nature and subject to boom and bust cycles. A business with inconsistent profits or cash flows can do very well with defined benefit plans, but it becomes more difficult in a down cycle.
Ideally, persistent and high cash flows and the expectation of decent cash flows over the foreseeable future make the most sense. We’ve seen companies in manufacturing, technology, distribution, real estate, and various services. It might make sense if a business owner earns more than $300,000 a year and is motivated by saving taxes.
Owners looking to maximize tax savings
Retirement savings are excellent. But lowering income tax is one of the best benefits and what drives the majority of business owners to defined benefit plans. Combining marginal state and federal tax rates can make these plans a no-brainer for business people searching for tax deferrals. Any defined benefit plan funding will come off at the owner’s marginal tax rate.
Many clients save over 40% in taxes when considering their marginal rates. But a cash balance plan can be especially appealing in states like California, where the top marginal income tax rate is 13.3%. With the maximum federal rate at 37%, employers who reside in states with no (or negligible) state tax can make a big difference.
How much can I contribute?
The defined benefit limits 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.