Defined benefit plans remain a little-known tax secret. They offer large tax-deductible contributions. But how much do you know about the defined benefit plan small business options?
There are many excellent strategies that you can use to maximize these plans. But by nature, these plans get a little complex.
In this article, we will show you how to structure these plans and offer you a few tips on how to implement. You just might see why we love these plans so much. Let’s jump in!
Table of contents
What are the Tax Benefits?
Tax policies encourage retirement savings. Favorable tax treatment on contributions, investment income, and benefits related to income accumulated for retirement.
Contributions by an employer towards a pension plan are deductible in corporate income tax computation. Employees also enjoy tax deferral on personal income until when they receive distributions from their plans. Tax deductions have improved retirement savings for many families in the U.S.
The plans specify that for a plan to qualify for tax deductions, it must meet minimum standards. These standards relate to participation, vesting, and non-discrimination against low-paid employees.
However, the IRS prescribes maximum tax deductible contributions. Contribution limits will vary depending on the type of plan, availability of more than one plan for employees, and whether the plan is top-heavy, meaning that owners and key employees benefit more from the plan.
Defined Benefit Plan Small Business Strategies
Annual contributions are generally driven by age and compensation. But the good news is that there is some flexibility.
Usually these plans are structured to allow minimum and maximum contributions that can be scaled up or down. All contributions are qualified and allow for an immediate tax deduction.
Employers have to ensure that the IRS approves of plan actions. The plan must comply with all plan requirements and IRS testing.
So the key is to play within the rules, but still maximize owner contributions. Let’s take a look at some of the strategies and an example.
Combine with Other Retirement Plans (like a 401k)
An advantage with a defined benefit plan is the combination of other retirement vehicles. In many cases, this is a 401k profit sharing plan.
The 401k plan will provide an extra contribution of $19,500 as an employee deferral ($26,000 if above 50 years old). It also can provide a 25% contribution from a profit sharing plan.
401k plans can be safe harbor plans. The employer makes a safe harbor plan contribution. Profit sharing contributions by an employer for the employee usually range from 5% to 7.5%.
Safe harbor plan make a 3% non-elective contribution. This can subtracted from the profit sharing contribution in the 5% to 7.5% range.
Consider Funding for Past Service
At this point we understand what a great tax planning tool these plans provide. But it gets even better.
Plans can be structured so that they provide for employee “past services.” You can go back from one to five years and examine compensation paid to employees. In the year of set-up, you would then make a one-time contribution for this past service. It’s almost like a “catch-up” contribution.
A small business owner can make maximum contributions that will exceed the targeted contribution in that year. This will enable the small business owner to get a tax deduction in a year when income will be high.
Let me show you a great example of a past service adjustment we did for a client. The client was 31 years old and had W2 income of $50k. Based on actuarial tables, he could only get approximately $15k into the plan for the current year.
But once we examined his W2s for the last 5 years, we were able to make a past service adjustment that allowed him to get another $105k into the plan. With only a W2 of $50k, he was able to get $120k into a plan. This is just one example. Not that bad.
But there are a couple things to consider. First, you have to include all employees in the plan. This can get expensive if there are a lot of employees. Second, providing for past service will essentially pull from future years. So it will result in high funding in year one and lower funding levels in subsequent years.
Third-Party Administrators (TPAs)
A third-party administrator (TPA) is an organization that offers administrative services or pension plans. Managing the administrative tasks is a challenge for employers. Accordingly, they usually contract a third-party administrator to handle much of the hefty administrative work. This allows the employer to concentrate on the remaining investment tasks.
Since not every employer is a financial expert, having a professional service provider manage retirement accounts is an ideal strategy; that’s where third party administrators or TPAs come in.
A TPA is a professional service provider (company or licensed individual) that manages retirement plans for companies. TPAs are responsible for taking care of the day-to-day management, administration activities, compliance, and filing returns on time.
How to Choose the Right TPA?
Sophistication and understanding of the regulations surrounding defined benefit plans aren’t the only qualities a TPA must possess. Ideally, your TPA should have prior experience in managing similar plans, be able to offer specialization as per your needs, offer competitive products, and communicate essential changes, options to the small business as well as the employees.
Experience of TPA
Every organization has specific, different financial goals and obligations towards their employees. A TPA should be able to analyze these goals and offer a suitable plan design, customizations for your business.
- Find out if the TPA has prior experience in providing similar services. Most of the TPAs won’t mind sharing the contact details of their previous clients. Speak with these companies and find out how the TPA helped them throughout the process.
- Make sure to keep your financial advisor in the loop, if not present in these meetings. Your financial advisor can help you understand critical terminology, intricacies of the plan design, and associated expenses.
Let’s Look at an Example
Peter is a small business owner who is taxed as a sole proprietor. He is age 60 and has no W-2 employees. He developed a software program for a company and was paid $615,000. Normally, Peter makes about $150,000 every year where he contributes about $40,000 annually to a 401k plan.
Because of the huge income made that year, Peter wants to set up a defined benefit plan to get an extra $200,000 plus into retirement for the current year. In subsequent years, he would want to make lower contributions. Peter has chosen to combine his 401k profit sharing plan with a defined benefit plan.
Peter makes the following contributions:
- Defined benefit plan = $170,000
- 401k deferral = $19,000
- 401k profit sharing = $18,000
- Total contribution = $207,000
Peter, therefore, got a huge tax deduction for his windfall income year and still can maintain lower contributions for future years. Peter can make smaller contributions to the defined benefit plan and chose to not make any contributions to the 401k or profit sharing plans since they are elective.
| Advantages | Disadvantages |
|---|---|
| Custom design plan structure | Permanent plan requirement |
| Allowable for any small business | Higher administrative costs |
| Qualify for full tax deduction | Must contribute for employees |
| Contributions over $100k | Mandatory annual contributions |
Bottom Line
America’s retirement problem is no secret. A recent survey from Bankrate finds that 1 in 5 Americans save nothing for retirement or other financial goals, whereas another 20% save less than 5% of their annual income. Only 16% of Americans are saving more than 15% of their yearly income.
Saving for retirement isn’t complicated. All one must do is to contribute consistently throughout his employment. The key to having sufficient retirement savings is to start early and stay disciplined. Considering the financial challenges retirees are facing at present, defined benefit plan small business options could be a blessing in disguise.
