What if you could increase your retirement contributions by over 400% and get a nice tax deduction? A defined benefit plan for small business might be the answer.
For sole proprietors and other business owners, defined benefit plans present an excellent retirement structure. These plans have been traditionally used by large businesses. However, they are available to sole proprietors and small businesses like S-Corps, C-Corps and partnerships.
A defined benefit pension plan is a retirement plan for self-employed business owners that allows for substantial contributions. Defined benefit plans are often combined with other structures, such as a 401(k) plan, to increase the overall retirement contribution.
|Pros ✅||Cons ✅|
|Min/Max Funding Range||IRS Permanency|
|Large Tax Deferral 👉||Conservative Investment Options|
|Contributions Over $100k 👉||High Administration Fees|
|Custom Document Design||Mandatory Plan Contributions|
Depending on your age and income, annual contributions can be as high as $350,000. Plus, they can also be combined with most 401(k) and profit-sharing plans. In this post, we will take a close look at how to structure a plan.
Table of contents
- Who is a Defined Benefit Plan Best For?
- Pension plan for sole proprietors
- Can You Have a 401(k) Plan and a Defined Benefit Plan?
- Defined Benefit Plan Vesting
- Defined Benefit Deadlines
- Investing Options & Strategy
- Terminating the Defined Benefit Plan
- Defined Benefit Plan for Small Business Tax Benefits
- Other Considerations
- Start a Sole Proprietorship Defined Benefit Plan
- Sole Proprietor Pension
Who is a Defined Benefit Plan Best For?
These plans have many advantages. But there are certainly some disadvantages that need to be considered.
As such, the first step is to take a look at what types of small businesses are good candidates. You’re probably curious whether a defined benefit plan would make sense for your company or not.
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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
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.
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.
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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.
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.
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.
Can You Have a 401(k) Plan and a Defined Benefit Plan?
Employers can offer multiple retirement account options, including a 401K plan with a defined benefit plan add-on. The limits for the 401(k) versus the cash balance plan vary greatly.
In 2023, the maximum 401(k) contributions are $22,500, with an add’l $7,500 catch-up contribution allowed for employees over 50 years old.
The limits for the defined benefit plan are based on the total lump sum limit allowed for withdrawal, which is $3.4 million or $265,000 in annuity payments.
Defined Benefit Plan Vesting
Defined benefit plans can have a vesting period of up to 3 years. This means employers can require three years of employment before an employee is vested. The employee is then 100% vested at the end of three years.
Suppose an employee leaves the company before the three years are up. In that case, they forfeit the defined benefit plan entirely, and the employer uses the accumulated funds to offset future cash balance account requirements.
Employers are optional to instill a 3-year vesting schedule, though. It is up to each employer.
Defined Benefit Deadlines
Defined benefit plan contributions by an employer are due by the earlier of the following:
- Business tax return due date with extensions
- 8 ½ months after the end of the plan year
Contributions are required annually and typically stay the same unless significant fluctuations occur in your annual income and investment performance.
Investing Options & Strategy
You can choose where to invest the assets as an employer, keeping the typical interest rate credit in mind. Most defined benefit plans pay an interest rate credit of 4% – 6%. This means your returns must equal at least that much. If they don’t, you must make a difference with your contributions.
It’s important to understand that employees must have individual investment accounts with a say in where the assets get invested. All funds are in a ‘pooled’ account in the name of the defined benefit plan.
The employer funds the account annually to ensure enough contributions to meet the hypothetical account balance. The plan advisor manages the investments to ensure the return is at least as much as the interest credit promised to each employee.
Most plan advisors use the following guidelines:
- Keep a conservative portfolio to prevent significant losses, putting the employer’s responsibility to make up the difference for the promised amounts.
- Keep the account manageable so the balance is higher than the necessary balance for eligible employees.
The target return is 5% for most defined benefit plan investment accounts. This is why you want defined benefit plan for small business investments to be conservative.
Terminating the Defined Benefit Plan
The defined benefit plan is permanent. Typically, you cannot terminate the plan unless you have a significant change in your business, including:
- Restructuring your business
- Changes in the law
- Financial issues
- Replacement with another benefit plan
Defined Benefit Plan for Small Business Tax Benefits
It’s no surprise that the number one reason people set these plans up is for the tax benefits. Most of our clients are in high-taxing states like California and New York. But we have clients spread out nationwide.
When your income is in a 50% tax bracket, like many of our California clients, getting an initial tax deduction for your contributions is a significant benefit.
These plans will allow you to take a significant deduction upfront and reduce or take this money out of the plan at retirement when you’re in a much lower tax bracket. The important part to note is that you can take advantage of the deductions in years when you have a high income. You also receive a flexible funding range, allowing you to contribute up to a maximum amount in a given year.
I began structuring these plans for clients of mine, physician clients, over a decade. Given their age and income, there needed to be a better tax, deduction, or structure.
Most physicians we work with are at least in their 40s and are taxed at the highest tax bracket. As such, it’s a simple plan to structure it to ensure it works for you.
Due to their low costs and light administrative requirements, defined contribution plans increasingly gain a considerable following. But many organizations still opt to continue providing defined benefit plans. Here are a few things to consider:
A defined benefit plan administration cost is usually borne by the plan sponsor, as the plan sponsor is liable for the value of the assets used to make benefits payments. A defined benefit plan can be a helpful retirement vehicle for business owners because the business is not exposed to the risk of the plan losing value. After all, the investments in the fund are not liquid. However, cash balance plans can be accessed before retirement and are particularly useful for entrepreneurs.
Start a Sole Proprietorship Defined Benefit Plan
Here are the five steps to setting up a plan:
- 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.
- 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.
- 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.
- 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 small business owner has different goals.
- 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 corporation||You 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 proprietorship||Partnerships are not sole proprietors, but they still have flow through taxation.|
|Can have qualifying employees||You 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 structures||Remember 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.
The defined benefit plan is an alternative to the defined contribution plans or can be utilized in conjunction with it. The defined benefit plan has replaced traditional pension plans in most cases and gives employers a little more leeway when preparing themselves or their employees for retirement.
There are vesting requirements, deadlines, and contribution limits you must abide by, along with rules regarding what you must offer your employees once you commit to the defined benefit plan.