Personal defined benefit plans are excellent retirement structures for the self-employed. But how much do you know about the rules? Maybe you would like to see an individual example?
These plans can boost your retirement contributions by an extra $100,000+ annually. While these plans allow large contributions, they can be complicated.
A personal defined benefit plan is entirely funded by the employer. Annual contributions are driven by several factors, including compensation, age, and investment returns. The company must contribute for any eligible employees.
Defined benefit plans can also be combined with retirement structures such as a 401(k) or a SEP IRA with certain restrictions. This can greatly increase the amount you can stash away for retirement.
Personal Defined Benefit Plan: Rules for Self-Employed:
- Allow contributions only to the individual solo business owner. As long as there are no eligible employees, the owner can be the sole participant.
- Different entity and tax structures are allowed. They can be used with S-Corps, C-Corps, Partnerships and sole proprietors.
- Contributions are tax deductible and investment returns are tax deferred. Average tax savings often exceed $50,000.
- They require a conservative asset allocation. Investment returns should average 5% to permit the annual funding and limit overfunding.
- The plans can be established and funded up the date you file your tax return. This allows business owners to target a year one contribution.
In this article, we will discuss how these plans work and point out a few tips and tricks. The goal is to give you some insight into how to set up a plan. Let’s jump in!
Table of contents
- What is a Personal Defined Benefit Plan?
- Can a Self-Employed Person Have a Defined Benefit Plan?
- Plan Advantages
- Who are the best candidates?
- Personal pension plan set up example
- Contribution Limits
- How to know if a personal defined benefit plan will work for you
- Bottom line
What is a Personal Defined Benefit Plan?
A defined benefit pension plan is a retirement plan for self-employed business owners that allows substantial contributions. Defined benefit plans can also be combined with other structures, such as a 401(k), which can increase annual retirement funding.
Under defined benefit plan rules a participant’s account earns a pay credit, normally 5% to 8% of the employee’s salary each year, plus an interest credit, at a fixed rate or variable rate on the account balance.
When the plan reaches its time to distribute the funds, you can move their funds to another tax-advantaged account in order to defer tax until when they require the distribution.
Defined benefit plans offer several tax advantages to both employers and employees:
- Tax-deductible contributions: Employers can deduct contributions made to the plan as a business expense. These contributions are subject to income tax once they are distributed to the employee.
- Tax-deferred growth: The investments held in the plan grow tax-free until the employee retires and begins receiving distributions.
- Higher contribution limits: Defined benefit plans generally have higher contribution limits than defined contribution plans, allowing employees to contribute more pre-tax dollars.
- No annual contribution limits: Unlike 401(k) plans, defined benefit plans do not have annual contribution limits, which means employees can contribute as much as necessary to fund their retirement.
- Pension income exclusions: When the employee begins receiving pension payments, a portion of the payments may be excluded from taxable income, depending on the employee’s age and the time the payments are expected to continue.
These tax advantages can help employers and employees save on taxes while providing a valuable retirement benefit. However, it’s important to note that defined benefit plans can be more complex and expensive to administer than other retirement plans.
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Employees have options at retirement. You can either choose to take it all at once, in one lump sum and roll it into an IRA or take an annuity.
Can a Self-Employed Person Have a Defined Benefit Plan?
To qualify for a self-employed (or “solo”) defined benefit plan, one has to have a substantial recurring surplus income from the business. The following criteria should also be met:
- Owner of a disregarded LLC that employs only the individual owner and spouse;
- Partner in a partnership that employs just the partners or partners and spouses;
- Sole owner of a corporation (or an LLC taxed as a corporation for example) that employs only the owner and spouse;
- Owner of the company who meets the above requirements and employs part-time employees, but all of them have not met the 1,000 hours requirement in a year starting from the date of employment.
An actuary makes an assumption of contributions towards a personal defined benefit plan by reviewing example investment returns on an annual basis. Specific assumptions and calculations used by an actuary ensure proper contribution levels that will ensure a personal defined benefit plan grows at a predetermined rate that secures a participant’s retirement period.
|Fee Structure||Plan Reporting|
|Plan Set Up = $1,200 to $2,000 ✅||Form 5500 ✅|
|Annual Administration = $2,000 to $4,000||Schedule SB|
|Participant Fees = $150||Actuarial Valuation Report|
|Loans, RMDs & Consulting||Annual Illustration|
What about a defined benefit plan for self-employed with an LLC?
Self-employed defined benefit plans are qualified plans. Therefore, business owners are assured of a tax deduction and high contribution levels. They are also protected from any bankruptcy lawsuit and can be rolled over to other IRAs or pension plans. Business owners should, therefore, take advantage of defined benefit plans coupled with other plans like 401(k) plans.
A personal defined benefit plan is solely funded with company contributions and is required to be funded on an annual basis. The plan actuary will calculate annual contribution amounts utilizing several factors, including W2 compensation, age and investment returns. If your company has eligible employees, you are required to contribute for them.
Let’s look at some of the advantages:
- Businesses will typically be able to contribute and deduct more than in a defined contribution plan.
- Contributions can be made after year-end and still take a tax deduction for the prior year (the rules allow this as long as they are made before the tax return is filed)
- For older self-employed individuals, the plan allows substantial contributions and provides a means of getting significant contributions over a small period.
- They can be combined with other qualified plans, such as 401k and profit-sharing plans.
- They can be established for owner-only businesses, 1099 employees, or large companies.
- Individual participant loans are allowed.
- There are no set contribution limits. An actuary calculates deduction limitations.
- Benefits are not based on asset returns. Therefore, it minimizes risk to the employees.
Do you own a business? Are you worried about retirement savings? What if there was a way to save more than $1 million in just a short time? It’s possible with the personal defined benefit plan.
Many advantages still render defined benefit plans likable by employees including guaranteed benefits, employer contributions and responsibilities and risks vested on the employer. It is, therefore, an important tool for employers for recruiting and retaining key employees.
However, employers have to ensure that they can sustain a defined benefit plan. They have to ensure that they have a constant cash flow which can maintain high contributions towards their plans over the period. They also have to meet high administrative costs and fees associated with the self-employed plans.
One thing to watch out for, however, is the fees. For most business owners, the benefits outweigh the fees, but they’re worth understanding:
- $1,000 – $2,000 to set it up
- $2,000 – $3,000 in annual fees
|Annual contributions of $100k+||Conservative investment profile|
|Custom plan design rules ✅||Mandatory contributions|
|Tax-deductible contributions ✅||Permanent plan structure|
|Flexible funding ranges||High administration costs|
Who are the best candidates?
Business owners that make more than $250,000 per year are ideal candidates. Plan contributions reduce your taxable income, which means substantial tax savings.
Defined benefit plans are great retirement vehicles. For many individual business owners, they are one of the best plans on the market. But they are not for everybody. There are some companies who are ideal candidates for self-employed plans.
But questions arise. Who are ideal candidates for defined benefit plans? What professions make most sense?
The truth is that there are many companies and professionals who are ideal candidates for defined benefit plans. The following are the top 5 ideal candidates:
- Companies with consistent profits (historically and forward looking)
- Professional service businesses (doctors, lawyers, CPAs, etc)
- Companies looking to improve morale and employee retention
- Owners trying to “catch-up” on retirement savings
- Owners or 1099 employees looking to maximize tax deductions
The truth is that you don’t have to have high profits for a defined benefit plans to make sense for you. But of course it helps.
Companies who have consistent profits (as an example) are great candidates. If your business is very cyclical in nature and subject to boom years as well as bust years it can be more challenging. In reality, even a company with inconsistent cash flows can do very well with defined benefit plans. But it becomes more difficult when times are challenged.
Ideally, consistently high cash flows and the through of decent cash flows over the foreseeable future make most sense. We have seen companies in manufacturing, distribution, real estate and a variety of service businesses. If a business owner makes in excess of $200,000 a year it might make sense to consider.
Professional Service Businesses
While any business industry can be a good candidate, professional service firms can work great. Professional service firms tend to have less overhead and higher earnings power than many business types. That’s why they are some of the best candidates.
Let’s look at an example of some professional service firms that could benefit from an individual self-employed plan:
- Attorneys and law firms
- Accountants and CPAs
Law firms, medical groups and 1099 independent contractors have historically been large proponents of defined benefit plans. Obviously, a large reason why are consistent high income. But these practices are looking for a way to get more money into practitioner’s retirement accounts.
Owners Behind on Retirement Savings
Let’s face it. Most people are behind on retirement savings. As they age, the try to get as much as possible contributed. But the problem is that life gets in the way. Kids need money for college – vacation plans get in the way.
As human beings we also can make every excuse possible to get behind on our retirement planning. Unfortunately, we need a plan to get more money contributed.
401(k) plans have maximum contribution limits around $67,000. This also assumes that the participant is over the age of 50. Owners and/or partners who want to contribute more than this are normally stuck. A cash balance plan can be a great fit for these people. Take a look at this cash balance plan example.
Individual Owners Looking to Maximize Tax Savings
Retirement savings is nice. But minimizing taxes is one of the best benefits and what drives the majority of business owners to defined benefit plans. When combining the marginal federal tax rates (with state tax rates as well), it makes a cash balance plan a no-brainer for business owners looking for tax savings. Any defined benefit plan contributions will come off at the owner’s marginal tax rate.
Most clients should save at least 40% in taxes when you consider their marginal rates. But in states like California where the top marginal income tax rate is 13.3%, a self-employed plan can be especially appealing. With the top federal rate at 39.6%, even employers who reside in states with no (or little) state tax it can make a big difference.
The best candidates have a combination on all the characteristics noted above. But most importantly, you should commit to the plan and all the benefits that come with it.
Personal pension plan set up example
- Put together a plan document outlining all the plan details, the contributions to be made and the interest rates.
- Open a personal defined benefit plan investment account. It is critical to follow the plan rules for set-up.
- Determine the amount of plan funding considering the age, compensation, plan document, actuarial assumption, and IRS regulations. Your plan actuary will assist you with this.
- After receiving the actuary contribution range, you can deposit funds to the plan account. Please note that your contributions must be made by your business’ tax –filing deadline, including extensions. The deadline is April 15, for unincorporated businesses including extensions, and March 15, including extensions for corporations and LLCs, organized as corporations. As such, the self-employed have many options.
- Look for a third-party administrator (TPA). Managing all plan activities and rules may be a difficult task for you, contact a third-party administrator to handle much of the hefty administrative work so you can concentrate on the remaining investment work.
Just like any other retirement plan, defined benefit plans also have rules and limits on the anl contribution.
Limits are age based. As a participant nears his retirement age, contribution limits are higher. For example, older people have fewer years to save. They often must squeeze twenty years into ten years of saving. Plan document, subject to IRS, specifies the contribution limit of a business owner.
You may be able to weight your contributions based on age. In other words, you may give slightly larger contributions to older loyal employees and a slightly smaller contribution to younger employees.
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How to know if a personal defined benefit plan will work for you
Here are the five steps in determining the correct plan structure.
- You are looking for large retirement contributions
Plans make sense for small business owners that are looking to contribute more than $50,000 per owner. You can terminate a plan as long as your intent is to have a permanent plan. But situations can change that required plan closure. But if you are looking for individual large contributions, these plans are your best option.
- You have consistent income
Companies should have large and reliable income and be able to contribute at least the minimum contribution amounts. This is often the case for professional services businesses, including physicians and attorneys. But any owner looking to make the large contributions are good candidates.
- You don’t think you will have any problems making contributions
Companies that can consistently make employee contributions year over year, along with a relatively decent interest rate. A business owner must make annual contributions. However, they can always freeze or terminate the plan (depending on business conditions and financial situation).
- You need to “catch-up” on retirement
Self-employed business owners who are behind on retirement and want to “turbo-charge” their contributions retirement. The personal defined benefit plan contribution is held in one large, pooled account. For example, upon retirement, each employee can take their account balance either as a lump sum payment or as annuity payments.
- You want to combined plans
Business owners can combine a 401(k) and a personal defined benefit plan simultaneously. This will enable larger overall contributions but allow the flexibility to not make the 401(k) contribution (if desired). As an owner, there are several strategies you can use to maximize your retirement savings. Just make sure you understand the rules.
It’s important to know and follow all IRS rules regarding the plan. It can be a great way to grow your own nest egg as an owner, while contributing to your employees’ retirement.
Using the tips above and including only loyal and ‘of age’ employees is the easiest way to have your own retirement plan from your company’s earnings, while helping those that work hard for you on a daily basis.
You have worked hard to build your business and now you want to build your retirement savings. A personal defined benefit plan may be the perfect option.