Defined benefit plans are a little known secret in the retirement arena. Maybe you understand them or possibly you are new to them. In either case, we have all the answers.
Table of contents
- Plan differences
- Why are defined benefit plans such a significant tax and retirement strategy?
- Plan options
- Risks & responsibilities
- Defined benefit plan basics
- Customizing a defined benefit plan
- Defined benefit plan rules
- Advanced defined benefit plan topics
- Defined benefit plan videos
- Defined benefit plan FAQs
When people first think of retirement planning, the first thought that comes to mind is usually a 401(k) plan or a SEP. These plans can be great options, but they have contribution limits that fall far short for many taxpayers. This is where a defined benefit plan should be considered because they have contribution limits that can exceed $300,000 annually, depending on certain factors like age and salary.
However, before we look at the details of the defined benefit plan, let’s first examine the two main types of retirement structures: defined benefit plans and defined contribution plans.
A defined benefit plan aims to provide eligible employees with a specified benefit at retirement. The benefit amount is contributed solely by the employer. It’s a specific amount that considers participants’ salaries and ages. Upon the average retirement age of 62, the employee can take the money out of the plan and pay tax at the employee’s ordinary tax rate. In theory, this rate is substantially lower than the high tax marginal rate that the employee is currently in.
In contrast, defined contribution plans (typically 401(k) plans) specify a maximum contribution that can be made by the employee (as a deferral) and the employer. In a defined contribution plan, the benefit amount at retirement depends on the cumulative plan contributions and interest income, and investment gains or losses.
How do defined benefit plans work?
The most common type of defined benefit plan is the cash balance plan. Even though it is a defined benefit plan, employee contribution amount and account balance feel like a 401(k) plan. The contribution is stated as an account balance compared to a monthly income payment presented in a traditionally defined benefit plan. For this reason, cash balance plans are often referred to as “hybrid” plans. Like 401(k) plans, cash balance plan distributions are taxed at the taxpayer’s ordinary tax rate upon distribution.
However, cash balance plans allow the employee to take a lump sum benefit equal to the vested account balance. If a retiree or terminated employee desires, a distribution can generally be rolled over into an IRA or another qualified plan.
But the surprising part is that these plans work great for small owner-only businesses and employers with less than 20 employees. But they can be a little more complex to set up and administer. So careful planning is imperative.
Why are defined benefit plans such a significant tax and retirement strategy?
Simply put, it allows the business owner to make substantial tax-deferred retirement contributions. Contribution limits are indexed and adjusted annually based on age. But annual contributions can often exceed $300,000, with $150,000 being the approximate average. This compares very favorably to the yearly limitations of a 401(k) plan.
Let’s take a look at an example. Assume a 56-year-old physician makes $500,000 a year and wants to maximize their retirement contribution. Let’s also assume that the physician has no qualifying full-time employees.
Because of his age and earnings, this doctor could contribute up to $230,000 to a defined benefit plan in the first year. The doctor can make additional contributions if the defined benefit plan is combined with a solo 401(k). Not such a bad deal.
These contributions are entirely tax-deductible and can be made up to the date the tax return is filed (including tax extensions). The contributions will grow tax-deferred but will be subject to tax at the presumably lower tax rate in retirement.
Take a look at the situation above. As you will notice, not many retirement structures allow such significant contributions. A 401(k) plan does not even come close.
Defined benefit plans are great options for:
- Business owners who have consistently high profits.
- Professional service companies (physicians, attorneys, consultants, etc.).
- Owners who have fallen behind on retirement and are looking to “catch up.”
- Owners in high tax brackets are looking for tax deferrals.
If you think a defined benefit plan is right for you, review your situation with your financial advisor and CPA. Hopefully, a defined benefit plan will become a beautiful tool in your retirement arsenal.
Defined benefit plans are qualified retirement plans and an IRS-approved tax deferral. Plans will be structured to include the following:
|Variable annual contributions||First-year contributions will have a relatively narrow range. But with each plan year, you will be given a contribution range. This range will include a minimum, maximum, and target amount. You can fund within the range, but the goal should be to stay close to the target. Do NOT fund your plan until you receive final contribution numbers from us. You have until eight and a half months after your plan year-end or until you file your tax return (whichever is earlier) to make your plan contribution.|
|The plan can be amended||You can amend the terms of your plan to increase your contribution amount. However, you cannot amend your plan to decrease contributions once employees become eligible for a benefit in a current year.|
|You can combine it with a 401(k)||Your defined benefit plan can be combined with a 401(k) profit-sharing plan (subject to limitations). This provides you with additional retirement contributions. 401(k) plans are generally elective. This will provide you with additional funding flexibility each year.|
|Distribution options||Once the plan is terminated, you can rollover the plan assets into an IRA or another qualified retirement plan. You will not be taxed until the assets are withdrawn from the new account. The IRS imposes certain limitations on distributions.|
|Plan termination||You can terminate your plan (subject to IRS rules). Depending on the assets in the plan, you might be required to contribute in the year of termination.|
|Plan TPA||We are solely a third-party administrator (TPA). We are not your CPA or financial advisor. You should seek the help of tax, legal and financial professionals before establishing a plan.|
Risks & responsibilities
While a defined benefit plan can provide you with sizable retirement contributions and tax deferrals, you need to be aware of certain plan risks and considerations. We will review these items during our onboarding call. But please make sure to clarify them with us. Below are several of the significant concerns:
Plan contributions are NOT elective. You are generally required to make annual contributions until the plan is terminated. This can be difficult for businesses with income volatility. If your business is subject to wide profit swings, discuss whether a defined benefit plan is the best option for you.
The plan is permanent. The IRS requires defined benefit plans to be permanent. However, the IRS allows plans to be terminated upon reasonable cause. If this is a problem, please discuss it with us.
Restrictions when combined with 401(k) plans. Even though defined benefit plans can be combined with 401(k) plans, particular limits exist. Profit-sharing contributions are limited to 6% of compensation instead of the standard 25%.
Restrictions on combining with other retirement plans. A defined benefit plan imposes restrictions when combining plans. Most SEPs are not allowed to be combined with defined benefit plans. Also, as noted above, there are limitations on profit-sharing contributions. If you consider establishing a defined benefit plan, you should stop contributing to other retirement plans until you decide. Typically, excess contributions to other plans can be reclassified or recharacterized.
Be careful of funding levels. Your plan will have a stated interest crediting rate. It would be best to attempt to grow your investment balance consistent with your plan rate. If your plan assets grow faster than the rate, it could lower future contributions. Likewise, if plan assets grow substantially less than the rate, contributions may increase in a subsequent year. Tax penalties can exist if your account becomes severely under or over-funded.
Communicate regularly with us. We gather information regarding your compensation, business profit, and plan assets annually. This information is necessary for filing required IRS returns and compliance to ensure your plan runs smoothly. Make sure that you communicate any business changes or concerns you have as quickly as possible. If you desire to increase or decrease annual contributions or terminate the plan, we would need to know as soon as possible.
Step 1: Review your illustration with your CPA and financial advisor
Our illustration has provided you with an estimate of your annual contribution amounts. Please review the illustration and pricing table with your CPA and financial advisor. If you are seeking higher or lower contributions, please let us know, and we can customize the plan for you. Please determine whether you would like to add a 401(k) plan for more significant funding and flexibility. Feel free to schedule a call with us to review your options.
Step 2: Complete our online set-up questionnaire
Included with the illustration was a link to our online new plan set-up questionnaire. Once you have decided to proceed with the plan, just complete and submit the online questionnaire.
Step 3: Plan adoption
Once we receive your completed online questionnaire, we will be in touch with any questions. Our standard processing time is 3-5 business days to complete all plan documents. We will then deliver your final plan documents and signature pages. Once you sign your documents, your plan is legal.
You will then receive an onboarding email and request for a 30-minute onboarding call. We can answer any remaining questions and clarify the plan’s terms in that call.
Step 4: Open your investment account
The next step is to open your investment account. We recommend that you fund no more than 50% of your estimated contribution amount until final contributions are calculated.
Defined benefit plan basics
Defined benefit plans can be very complex. In the following posts, we examine some of the basics in plan structure.
- Defined Benefit Retirement Plan: The Complete Guide
- Can you have a defined benefit plan and a 401k plan?
- How Much Does a Defined Benefit Plan Cost? Low Fee Providers
- Advantages of Defined Benefit Plans: Our Top 10 List
- Difference Between Defined Benefit Plan and Defined Contribution Plan
- FREE Cash Balance Plan or Defined Benefit Plan? The Secret Revealed
- How to Set Up a Defined Benefit Plan: 5 Start Up Tips – (emparion.com)
Customizing a defined benefit plan
Now that you understand some of the basics, let’s look at some of the ways you can customize a plan to meet your needs. Take a look at some of our posts on plan structure.
- DB Plan: Top Defined Benefit Pension Plan Strategies 
- Defined Benefit Plan for S Corps ≈ Top 5 Strategies
- Top 5 Defined Benefit Plan Tax Strategies for 2021
- Defined Benefit Plan Sole Proprietor ≈ 5 Easy Steps
Defined benefit plan rules
Every retirement plan aims to maximize retirement savings while also providing a tax deduction. Defined benefit plans are no different.
Section 401(a) of the Tax Code specifies defined benefit plans as qualified plans. Therefore, sole proprietors, S-Corporations, C-Corporations, and those in a partnership are allowed a tax deduction from their taxable income for the contributions made towards a defined benefit plan.
Defined benefit plans are preferred by business owners and key employees with high income, like medical practitioners and accountants. Tax deductions have a heightened ability to assist business owners in saving money through tax deductions. If a business owner and spouse, also considered a business owner, file jointly, they can enjoy up to $600,000 on deductions from January 1, 2018, under the new tax laws passed in 2017.
Retirement saving years can also be reduced. In fact, defined benefit plans can squeeze 20 saving years to just ten. Contribution limits increase as age nears retirement. Another advantage is that they can be combined with other 401(k) plans and profit-sharing maximum contributions and tax deductions.
Employees also prefer a defined benefit plan due to their reduced burden. Employers or sponsors do all the tasks, from making contributions to taking risks and planning responsibilities. However, the sponsor can appoint a third-party administrator (TPA) to help with administrative duties while he concentrates on plan investments.
Pass-through businesses and the 20% tax deduction
Pass-through businesses, including partners, S-corporations, and sole proprietors, have everything to smile about the 2017 tax reforms, which came into effect starting January 1, 2018. Pass-through businesses can now make a deduction of 20% from qualified business income, thanks to the 2017 tax reform legislation.
However, the rule does not apply equally to all business owners. It restricts service businesses like accountants, doctors, or attorneys if taxable income exceeds a specified threshold. If over the limit, they must implement additional tax strategies to lower taxable income to qualify for the defined benefit plan tax deduction.
Business owners may realize that contributing to a defined benefit plan may be one of the best approaches to staying below the threshold. The specified point is $157,500 for single filers and $315,500 for married filers plus a phase-out of $50,000 for an individual filer and $100,000 for married filers. A professional service owner with over $207,500 of taxable income (or $415,500 joint) does not qualify for the 20% deduction.
Defined benefit plans allow business owners to minimize taxable income. Defined benefit plan contributions can be as high as $300,000. This is substantially higher than allowable contributions on a 401(k) plan.
Combining the defined benefit plan, 401 (k), and profit-sharing, a business owner can contribute a maximum of $3.1 million from business income.
defined benefit plan tax deduction requirements
The sole proprietor in a defined benefit plan dramatically benefits from the 20% tax deduction because the tax is on general business income and not at an individual level. Therefore, partners and business owners in an S-corporation must split the tax deduction benefit. With the non-discriminatory rule, business owners have to include and pay for low-income employees, further dividing the tax deduction benefit. Charitable contributions are also tax-deductible (subject to AGI limitations).
Defined benefit plans, other retirement plans, and charitable contributions to public charities and approved private foundations significantly reduce taxable business income. A business, therefore, can use these strategies to ensure eligibility for the 20% tax deduction.
Defined Benefit Plan Tax Deduction: Best Candidates?
Defined benefit plans require high business income or high employment income. Due to restrictions applied to a 20% tax deduction, high contributions under a defined benefit plan can be a solution. The following groups will often benefit most from a defined benefit plan:
Lawyers, physicians, CPAs, financial planners, engineers, and consultants;
Business owners who have sustainable above-average income;
Older business owners with limited retirement funds;
Companies who desire to attract and retain employees critical to the company’s growth and operation; and
High-income earners are looking to take advantage of tax deductions and retirement planning benefits.
Defined benefit plans are effective when used well to reduce tax effects on a business or individual level. However, ensure that constant business income or cash flow is available to fund the plan. You can also use a TPA, a CPA, and an actuary to reduce your administrative tasks and manage your plan optimally. Also, ensure that you make contributions by the plan tax return due date, including extensions to enjoy the tax deduction tools.
- Deadline to Establish a Defined Benefit Plan [Updated for 2021]
- Defined Benefit Plan Example ∼ 5 Surprising Examples
- Defined Benefit Plan: $1 Million in 10 Steps [Example]
- 2021 Defined Benefit Plan Contribution Limits: Rule to $1 Million
Advanced defined benefit plan topics
A qualified employee plan designed to provide participants with a definite, specified benefit at retirement is known as a defined benefit plan. The benefits provided by the plan determine the contributions that must be made to it. In simple terms—and without considering the effects of plan earnings—if an employer must accumulate $100,000 to fund a particular participant’s income benefit beginning at age 65 and the participant enters the plan at age 55, the employer must contribute $10,000 each year to the plan. ($10,000 annual contribution x 10 years = $100,000)
However, if the same participant entered the plan at age 45 (thereby giving the employer 20 years to accumulate the needed funds), the employer’s annual contribution is cut in half. ($5,000 annual contribution x 20 years = $100,000) Plan earnings or losses will affect the employer’s contribution to the plan each year. Because of that plan design, the length of the participant’s accumulation period before they retire significantly affects the size of the required contribution.
Clearly, the shorter the accumulation period is, the larger the contribution must generally be. Each year, the contribution in a defined benefit plan will change—although, usually, only slightly—from the previous year. As a result of this variability, however, defined benefit plans must calculate the contribution needed to fund each participant’s benefit promised by the plan.
- 10 Effective Strategies for Overfunded Defined Benefit Plans
- The Complete Guide to Employee Vesting for Defined Benefit Plans
- Terminating a Defined Benefit Plan: Our 10 Step Process
- Can You Have a Self-Directed Defined Benefit Plan? The Surprising Answer
Defined benefit plan videos
That’s fine if you are more of a visual person. Take a look at our collection of videos below and learn a bit more about how the plans work.
- Defined Benefit Plans for S-Corps
- Vanguard Defined Benefit Plans: Here’s What They Don’t Tell You
- Can a Defined Benefit Plan be Combined with a 401(k) Plan? The Surprising DB Plan Combo
- Form 5500-EZ: The Quick Step by Step Guide
Defined benefit plan FAQs
By now you have probably heard about all the tax and retirement benefits relating to defined benefit plans. But let’s face it…they can be difficult to understand.
That’s why we have completed this list of FAQs. If you have a question that isn’t answered here just leave us a comment below. We will continually update this page so that it is as comprehensive as possible.