OK I admit it. Understanding a defined benefit pension plan can be challenging. But once you get the basics, you will see that they are one of the best retirement strategies.
My goal is to make this as simple as possible. But when it comes to defined benefit plans, nothing is simple. We’ll take a look at some of the rules and requirements and then look at some little-known tax strategies. Let’s get started.
Table of contents
Step #1: The Basics
When most folks think of a retirement plan they typically think first of a 401k plan. But we want to introduce the defined benefit plan.
401ks are certainly great options. But they do not allow a participant to maximize contributions. That is where a defined benefit plan comes into the picture. But before we examine the defined benefit plan, let’s take a closer look at the two main types of pension plans.
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There are two specific types of retirement plans available in the marketplace — defined benefit plans and defined contribution plans. The main goal of a defined benefit plan is to provide a specific benefit at retirement for eligible employees. This would be similar to social security.
For example, an employee would be guaranteed a specific benefit at retirement. An employee has accumulated a benefit amount by the age of 65 and then decides to retire. He or she will be entitled to receive a monthly annuity payment. This might be $9,000 annually for life (or $750 a month).
However, defined contribution plans specify a contribution that can be made by the employee and employer. With a defined contribution plan, the actual amount of retirement benefits provided to an employee depends on the entire contributions made to the plan combined with the cumulative gains and losses.
Defined benefit plans come in different shapes and sizes. They have the ability to define the benefit in terms that are similar to a defined contribution plan. Said differently, they can define the promised employee benefit in terms of a specific stated account balance.
Step #2: The Rules
In a typical defined benefit plan structures as a cash balance, the participant account is credited each year with a “pay credit”. This could be, for example, 5-7% of compensation as specified by the employer. In addition, the participant account receives an “interest credit”. This can be either a fixed rate or a variable rate that is linked to an index (like a a treasury bill or note).
Any increases or decreases in the overall value of the investments in the plan do not directly impact any benefits promised to participants. As a result, any investment risk is the responsibility of the employer (plan sponsor).
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When an employee is entitled to receive benefits, they are often stated in terms of an account balance. For example, let’s assume that a participant has an account balance of $250,000 when he or she reaches age 65. Should the employee decide to retire, he or she would have the right to an annuity payment based on the account balance. For example, the annuity might be $20,000 a year for life.
However, many defined benefit plans allow the participant to choose to take a lump sum benefit equal to the $250,000 account balance. If a retiree receives a lump sum distribution, that distribution will generally be rolled over into an IRA or possibly to another qualified plan (if that plan accepts rollovers).
Step #3: The Specifics
Defined benefit plans are required to offer payment of an employee’s benefit in the form of a series of payments for life (much like an annuity). For traditional defined benefit plans, the payments would begin at retirement.
But certain defined benefit plans define the benefit in terms of a stated account balance. These accounts are generally referred to as “hypothetical accounts” because they do not reflect the actual contributions to the account. They merely the stated account balance pursuant to the plan document.
Step #4: The Strategy
Simply stated, it allows the employee to contribute a substantial amount into retirement and take a sizable tax deduction. Let’s look at an example.
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Assume a 55 year old medical doctor who earns $500,000 a year. Let’s also assume that the doctor is the only qualifying full time employee. Depending on final compensation, this doctor could contribute approximately $225,000 into a defined benefit plan.
If the defined benefit plan is combined with a solo 401k that provides profit sharing, the doctor can contribution an additional $37,000. This is a total of $257,000. Assuming an income tax rate of approximately 40%, this is a tax savings of $104,000. Not too bad.
Step #5: The Amendments
The defined benefit can be amended, but if it is changed too often the IRS may investigate and declare the changes to be abusive. If changes are made, they should not be made often.
This is why it is important to determine if cash flow is fluid and expected over coming years. If something happens to the business that changes cash flow, this can cause significant problems with the defined benefit plan and lead to problems with meeting the obligation for the benefit plan.
The plan can be set up to run for just a few years, but in general it is expected that the plan will continue at least three years. At the time of termination of the plan, if the individual is not of retirement age they may roll the funds into an IRA. This will allow assets to continue to grow tax-deferred.
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It is important to note that defined benefit plans cannot be terminated easily. Once they are set up, it is expected and required that they are funded each year. You can run your numbers through our defined benefit calculator.
This is especially important for proprietors who have employees who qualify for the plan. If cash flow of the business changes in the future and becomes less profitable, a large required pension contribution can be detrimental to the financial health of the business.
Final Thoughts
Considering the above example, there just are not many retirement options that will allow for such a large contribution. If you think a defined benefit plan is right for you, make sure that you review your situation with your CPA and a third party administrator. Hopefully, this dummies post was helpful and the defined benefit plan becomes a significant tool in your retirement arsenal.
