Sole Proprietor Defined Benefit Plan ≈ 5 Easy Steps [+ Pitfalls]


What if you could increase your retirement contributions by over 400% and get a nice tax deduction?

For sole proprietors, defined benefit plans pose a good retirement contribution. While being defined benefit plans, they also have certain traits that are similar to those of defined contribution plans. As such, people call them “hybrid plans”.

Sole proprietors are eligible for a defined benefit plan. Depending on your age and income, annual contributions can be much larger than the $61,000 cap available with most 401k and profit-sharing plans.

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At the same time, it’s hard not to have some curiosities regarding a defined benefit plan. That being said, you’re inclined to ask about the type of companies that would serve as good candidates for the said plans. More than that, you’re probably curious whether a defined benefit plan would make sense for your company or not.

Well, there are many types of businesses and professionals that would be amazing candidates for defined benefit plans, such as the following:

  • Owners who try to catch up on retirement savings
  • Companies that have consistent profits
  • Owners who want to maximize their tax deductions
  • Service proprietorships and professional service businesses
  • Companies that want to improve employee retention and morale

Pension plan for sole proprietors

Defined benefit plans are defined benefits that basically specify how much contribution will be credited to each participant. It guarantees the earnings from the investment on those contributions. Each person that participates in them has an individual account that resembles the accounts in a 401 (k) profit sharing plan. Then, each account is administered by a third party administrator, which generates statements for the participants every year.

Consistent Profitability

Despite being of help, you actually don’t need high profits for a cash balance to make sense for you. Consistency is the one that matters the most, as companies who have it are usually great candidates.

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Inconsistency is not beneficial when it comes to defined benefit plans. It doesn’t mean that a company with inconsistent cash flows is unable to do well with cash balance times. However, consistency is preferred, as it prevents you from going through hardship because of them once things get too challenging.

Under the rules, consistent high cash flows over the foreseeable future make the most sense. Therefore, if a company makes about $300,000 or more annually, considering these plans might be of help.

Whereas they maintain the individual accounts of employees like a defined contribution plan, defined benefit plans fall under the rules of defined benefits plan. Defined benefit plans for a sole proprietorship are meant for those who have a set surplus income or a recurring consulting outcome.

This person should also take interest in making some retirement contributions of a significant amount. Defined benefit plans allow you to save more than $2 million for retirement.

Because it resembles a 401 (k) plan, the defined benefit plan of a sole proprietor is usually considered a hybrid plan. Generally, the account of a participant gains a pay credit that should be of about 5% of their yearly salary.

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Besides this, it also gains a variable rate, fixed rate or interest credit on the account balance. If you decide to terminate the plan, the money can be moved to another tax-advantaged account, so you can defer tax until you can take a distribution in a formal way.

Start a Sole Proprietorship Defined Benefit Plan

Here are the five steps to setting up a plan:

  1. Adopt the Plan

    There are a few steps in setting up a plan. The first step is to adopt the plan, which consists of having the administrator draft. This draft must outline all the details of the plan, as well as the interest rates and the contributions to be made. Compliance can be more challenging with defined benefit plans. Also, remember that these plans are permanent.

  2. Establish an Account for the Plan

    The next step would be to open a sole proprietorship defined benefit plan account. In the event that the plan accommodates either the spouse or partners and their spouses, one account will be used to store all the contributions.

  3. Get the Numbers

    Make sure to determine the amount of plan funding by taking the plan document, IRS regulations, compensation, age and actuarial assumption into consideration. Your plan actuary will help you with this but you can also get a draft of the results with an online calculator. Remember these plans can be complex. Make sure to discuss them with your CPA, financial advisor and TPA.

  4. Fund the Plan

    Once you’re done with all the above steps, you are ready to deposit the money into the account for the sole proprietor defined benefit plan. Keep in mind – you must make the contributions before the business tax filing deadline, including extensions. Review the final plan design and make sure it suits your financial and tax strategy. Each business owner has different goals.

  5. Look for Third-Party Administrators

    A TPA will be able to administer the plan. Managing the plans is not a child’s play, so you need someone who can properly handle some of the work. Don’t forget to discuss any changes or enhancements to your plan with your TPA. You want to customize the plan upfront.

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The table below spells out a few critical issues:

Can’t be a corporationYou must own an unincorporated business that employs the owner and spouse only. S-Corps and C-corps do not qualify as sole proprietors.
A partnership is not a sole proprietorshipPartnerships are not sole proprietors, but they still have flow through taxation.
Can have qualifying employeesYou must own the company that meets all the above requirements, but you can have eligible employees. This would not be a solo plan, but would still be a sole proprietorship.
Can combine with other retirement structuresRemember that the defined benefit plan can be combined with other retirement structures (like a 401k). But there are restrictions and limitations.

Sole Proprietor Pension

If you end up making these plans, you will be funded annually, thus getting funds for your retirement. Through this article, you should have all the information you need to know whether you should set up a sole proprietor defined benefit plan.

Paul Sundin

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