If you are looking to get over $100,000 into retirement annually with a full tax deduction, you don’t have many options. But a personal defined benefit plan might be what you are looking for.
A personal defined benefit plan could be a good solution. Here’s how it works and what you must know.
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What is a Personal Defined Benefit Plan?
Defined benefit plans have a predetermined annual contribution or pay credit and a predefined rate. Unlike a 401K, the balance isn’t determined by an investment’s performance. There is a predetermined rate of return that is what drives investment managers’ decisions on what investments to consider.
At retirement, you can choose to take the funds as a lump sum or monthly payments. The limits for personal defined benefit plan contributions are much higher than an IRA or 401(K) and depend on your age can be as high as $300,000 annually.
You can also front-load your contribution stream to match tax deductions with your expected income. You can also vary your contributions based on your business income to minimize taxable income.
Another benefit of a defined benefit plan for the self-employed is its ability to provide substantial tax savings. Because payroll taxes are based on wages paid, a higher amount of money can go into the plan. Because of these advantages, a defined benefit plan may be a worthwhile investment for a business owner.
Another benefit is that contributions to a defined benefit plan can be tax-deductible as business expenses. Combined with other retirement options, a defined benefit plan can provide a higher annual retirement income while reducing the risk of lawsuits.
A defined benefit plan for the self-employed is a great way to maximize your retirement savings. Unlike a traditional retirement plan, a defined benefit plan can be more complicated to set up and administer.
But if you make a lot of money, a defined benefit plan may be your best option. It has the benefit of allowing you to catch up on your retirement savings. When you plan for your future, the benefits can be significant.
How it Works
Defined benefit plans have hypothetical account balances. It sounds odd, but it’s based on the predetermined contributions and rate of return. They are not based on the actual performance of individual investments like a 401(K).
The business carries the risk of making up the difference in the hypothetical account balance at retirement if the investments didn’t reach their full potential. All funds grow tax-free, and withdrawals are taxed at your retirement tax bracket.
If you choose a lump sum payout at retirement, you can roll it over into an IRA to avoid taxation on the full amount and control how much you receive throughout retirement.
There are several benefits of a defined benefit plan for the self-employed. Benefits are guaranteed, contributions are fixed, and employer responsibilities are clearly defined. It can be an effective tool for recruiting and retaining key employees.
It requires a steady cash flow to support high contributions and administrative expenses, such as consulting fees. But it isn’t for everyone. Read on to learn how defined benefit plans work and why self-employed should consider one.
One of the benefits of a defined benefit plan for the self-employed is its ability to allow you to make significant deductible contributions. Whether you front-load your contribution stream depends on your income and business. If you have a strong year, you may opt for a higher contribution amount than you expected to earn.
The Benefits of a Personal Defined Benefit Plan
Business owners greatly benefit from a personal defined benefit plan because you can catch up on your retirement contributions quickly. If you didn’t contribute to your retirement accounts for the last few years while you set up your business, you may feel behind. The defined benefit plan allows plenty of room to catch up.
As a participant, you don’t have any risk in how much is in your account at retirement, since it’s the business’s responsibility to make up the difference. Even though you are the owner, it won’t come out of your personal pocketbook, but instead, the business’s value.
Another benefit of the defined benefit plan is the tax deductions. All contributions are pre-tax. This means your business avoids tax payment on the funds you contribute to your defined benefit plan. Like we said earlier, the funds grow tax-free in your account too. You don’t pay taxes until you withdraw the funds.
If you have a pass-through entity such as a sole proprietorship or partnership, it decreases your tax liability personally since all taxes are passed through to you personally.
Finally, defined benefit plans, like 401(K) accounts, are protected from creditors. This means if you or your business must file bankruptcy, your creditors cannot come after your defined benefit plan. You’ll still be set up for retirement.
The Downsides of the Plan
It’s important to understand the good and the bad sides of a cash balance plan. While there are plenty of reasons to consider one, there are some disadvantages including:
- There are strict IRS guidelines and regulations that can get confusing
- Employers face high administrative costs
- The plan could require large contributions which could be hard for the business to afford consistently
There are plenty of pros, so let’s take a look at a few:
1) Large funding amounts. Plan contributions will far exceed contributions to a 401k plan or SEP.
2) Tax-deductible contributions. They are qualified plans, which means all contributions are tax-deductible. 3) Ability to integrate with other plans. The plans can be combined with other retirement structures to provide a maximum contribution.
4) Age-weighted contributions. Contributions continue to increase as you age, enabling those close to retirement to make higher contributions.
5) Funding flexibility. A funding range includes a minimum, maximum, and target contribution.
As with any retirement structure, there can be some disadvantages. Let’s take a look.
1) Plan cost. Since plans require an actuary sign-off, the plans cost substantially more than most retirement plans.
2) Permanency. Unlike defined contribution plans, defined benefit plans are not elective. As such, annual contributions are typically required.
3) Conservative investments. The plans will have an interest credit rate. The goal is to minimize volatility and get a return approximating the crediting rate.
Who Should Consider a Defined Benefit Plan?
Defined benefit plans aren’t right for everyone, but here are some things to consider to decide if it’s right for your company.
- You want to contribute more than $20,500 to your plan. If you need to catch up on retirement contributions, or worry about not having enough for retirement, a traditional 401(K) plan may not be enough. You can only contribute $20,500 with an additional $6,500 if you’re over age 50 in a 401(K). The limits are much higher in a defined benefit plan.
- Your company has consistent cash flow. If your company is established and consistently earns profits, it can likely afford to pay the larger contributions toward your retirement. Not only will you set yourself up for the future, but you’ll also reduce your tax liabilities.
- You are ‘older.’ Defined benefit plan contribution limits are based on your age. The older you are the more you can contribute and like we said above, the limits can get as high as $341,000, which is much more than a 401K plan allows.
The Difference Between a Defined Benefit Plan and 401(K)
You might wonder what the difference between a defined benefit plan and 401(K) is since they sound so similar.
First, the contribution limits are vastly different. You can contribute much less to a 401(K) than you can a defined benefit plan.
Second and most notably, there’s no guarantee on your 401K balance. It’s dependent on the market’s performance which means your balance and fluctuate considerably. There’s no guarantee you’ll have a set amount of money at retirement.
A defined benefit plan has a guaranteed balance which becomes the business’s responsibility to make up the difference if the balance isn’t the promised balance at retirement.
| Pros | Cons |
|---|---|
| For Owner Only | Permanent Plan Design |
| Custom Plan Structure | Higher Plan Costs |
| Tax-Deductible Funding | Mandatory Plan Contributions |
| Flexible Contribution Range | Complex Structure |
In addition, employers can invest the defined benefit plan funds just like they can invest other defined benefit plan funds. Participants’ retirement accounts grow by earning annual credits based on a flat percentage of pay and could be integrated with Social Security benefits.
In addition, accounts earn an interest credit each year that is tied to some external index, such as the Consumer Price Index or the rate on U.S. Treasury bills. Benefit accrual formulas based on an employee’s career average earnings tend to be more beneficial to employees just beginning their careers than employees who are close to retirement and have worked most of their employment under a more traditional defined benefit plan.
Final Thoughts
If you want to catch up your contributions or ensure you have enough for retirement while decreasing your tax liability, talk to your tax advisor about a defined benefit plan.
If you own your own business and don’t have employees, you may wonder how you’ll contribute to or catch up on your retirement accounts. If retirement isn’t too far off, an IRA won’t be enough to keep you afloat during retirement. The contribution limits are too low.
While it has regulations that can be strict and require more work on your end, it can help you have the money needed for retirement, which is most business owner’s goals in owning a business – setting themselves up for the future.
