Defined Benefit Plan Example 5 Surprising Examples


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Defined benefit plans are certainly more complex than 401k plans. But there are also significant tax advantages. Especially with the introduction of the Tax Cuts and Jobs Act (TCJA). The best way to understand the plan is to take a look at a few defined benefit plan examples.

The TCJA introduced the concept of a tax deduction for QBI (qualified business income). This made defined benefit plans much more powerful.

The tax deduction is up to 20% of a business’s qualified income, or 50% of W-2 wages paid. However, the deduction begins to phase out at $315,300 for married couples filing jointly, $207,500 for heads of households and $157,500 for single filers.

Individuals who earn more than the limit can set-up a defined benefit plan to bring their income under the limit. Defined benefit plans can also be combined with 401ks to further reduce income and save tax dollars.

We know that understanding defined benefit plans can be a challenge. So what better way to understand how a plan works than to take a look at an example? We take a close look in this post at 5 defined benefit plan examples.

Defined Benefit Plan Example #1: The Dentist

Dr. Giles is a 38 year old dentist. He worked for a large clinic and decided to start his own practice. His attorney set up an LLC that was a disregarded entity and so it was taxed as a sole proprietor. He had four part-time employees. None of them qualified for any retirement contributions. His net income after business expenses was $390,000.

The next step was to combine a 401k plan, profit sharing plan, and a defined benefit plan. He contributed $70,000 towards a defined benefit plan, $18,500 to the 401k and $16,000 to the profit sharing plan for a total of $104,500.

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When he worked at the clinic, he was only able to contribute $18,000 towards the 401k plan offered by the employer. He now contributes over $85,000 more towards his retirement and is able to enjoy sizable a tax deduction.

Defined Benefit Plan Examples #3: The Chiropractors

Dr. Aaron and Dr. Sarah are married and work together as self-employed chiropractors earning a combined income of $940,000. Their business is an S corporation where they have no W-2 employees.

Dr. Aaron is age 46 and Dr. Sarah is 44. Being in a 40% combined tax bracket, they wished to maximize their contributions in order to reduce their tax liability. Their CPA proposes working on individual W-2 incomes to maximize their contributions.

They, therefore, combined a 401k plan, profit sharing plan and defined benefit plan. The defined benefit plan was also funded, in part, with an annuity. This maximized their annual tax-deductible contributions. The annuity are guaranteed by the insurance company.

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For Dr. Aaron, his income is $700,000 and he takes a wage of $280,000 (the IRS maximum compensation that can be utilized to calculate plan contributions). He, therefore, makes the following contributions; $19,000 to a 401k plan, $16,200 to profit sharing plan and $150,000 in the defined benefit plan combined between the annuity and mutual funds. Total contribution for Dr. Aaron is $184,000.

Dr. Sarah, on the other hand, makes an income of $240,000 and pays herself a W-2 salary of $130,000. She also makes total contributions of $109,000 as follows; $19,000 for a 401k plan, $7,800 for profit sharing plan, and $83,000 in the defined benefit plan combined between the annuity and stocks.

In 2019, combined contributions towards 401k and profit sharing plans were $60,000. This limit is subject to IRS regulations and increases on an annual basis. 401k and profit sharing plans values are determined using market performance at retirement age and are not guaranteed like the defined benefit plan. 401k and profit sharing plans, therefore, supplement the $4.3 million guaranteed minimum available for them when they retire.

Other benefits available for Dr. Aaron and Dr. Sarah under this option are:

  • Aggressive retirement savings (total annual contribution of $293,748)
  • Huge tax deduction of $293,748. Being in a 40% marginal tax bracket, they manage to save $109,471 in income taxes.
  • The life insurance is a good source of protection for their family in case of a premature death. If they live to the maximum span of the permanent life insurance, it will be used for estate planning and to leave a legacy for their children or grandchildren.
  • They also have the ability to combine 401k, profit sharing, and defined benefit plans to maximize their contributions and tax deductions.

Defined Benefit Plan Example #4: The Engineer

Joseph is a 38-year-old engineer married to Mary and have two young children. Joseph owns an S corporation where he makes $290,000 after expenses and after a W-2 salary of $280,000. His wife Mary works as an office manager for the business. She gets a W-2 salary of $50,000. Joseph has no other W-2 employees.

Because of their modest lifestyle, they are opting to maximize their annual contributions. As an income producer for the family, Joseph needs a life insurance to protect the family in case of a premature death. Both Joseph and Mary own $500,000 of term life insurance each, and Mary will not need an extra cover. Joseph decides to take a $3 million whole life insurance which is permitted by IRS.

To maximize their contributions, they set up a combination of 401k profit sharing plan coupled with a fully insured defined benefit plan for their S corporation where Joseph and Mary are both eligible. Not many people realize that life insurance can be used in a defined benefit plan.

Joseph’s contribution came to a total of $111,000 calculated as follows; $19,000 for 401k, $16,000 for profit sharing and $76,000 in the defined benefit plan combined between the annuity and $3 million of whole life insurance.

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Mary, on the other hand, can make a total of $42,000 contributions from the W-2 salary of $50,000. The calculations are: $19,000 for the 401k plan, $3,000 for profit sharing and $21,000 in the defined benefit plan. Her minimum guaranteed policy value for the annuity is $638,348 the moment she retires at 65.

Under this option, the following advantages accrue to Joseph and Mary.

  • Aggressive retirement savings, a combined total of $153,000.
  • Massive tax deduction of $153,766 which means a federal tax savings of $60,891 using a 40% marginal tax bracket.
  • Joseph acquired a $3 million permanent whole life insurance to serve as a protection in case of a premature death or to be used for estate planning if he lives a long healthy life.
  • Based on defined benefit plan contributions made, Joseph’s $76,000 and Mary’s $21,000, they have a combined $3.3 million guaranteed minimum value of both annuities and guaranteed cash value when they retire.
  • They also have the ability to include 401k and profit sharing plans. They made a contribution of $55,200 in 2017, although their value will be determined by the market performance, the will act as a supplement to the guaranteed cash values in the defined benefit plan.

Defined Benefit Plan Example #5: The 20% QBI Deduction

This next example is meant to illustrate how a plan can be used in conjunction with the TCJA. Let’s look at an example of a married sole proprietor earning $500,000 per year through their business. This couple could invest $56,000 into a one-participant 401(k), effectively reducing their taxable wages to $444,000. To qualify for the QBI deduction, they would need to reduce income an additional $128,700. To do so, they could set up a defined benefit plan with an actuarial administrator.

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The plan administrator could determine the required future income and yearly contributions for the plan to bring the taxable wages under the $315,300 limit. The TCJA QBI deduction is set to expire at the end of 2025. The sole proprietor could set up the defined benefit plan to end at that time and roll the assets tax-free into an IRA. This would allow the sole proprietor to protect current income and assets, but also allow for future adjustments if tax laws change.

If the QBI deduction is renewed in 2025, the sole proprietor could extend the defined benefit plan an additional period of time if they planned to continue working and expected to be able to continue to meet future contribution obligations.

Considering the above examples, there just are not many retirement options that will allow for such a large contribution. If you think a defined benefit balance plan is right for you, please review your tax and financial situation with your CPA and a third party administrator. Hopefully, the defined benefit plan can become a significant weapon in your retirement arsenal.

Paul Sundin

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