What if you could funnel an additional $3 million into retirement and get a tax deduction in the process? With such high contribution limits, many clients set up a solo defined benefit plan.
If structured correctly, these plans are one of the best tools a business owner can use to accelerate retirement savings. But they are complex structures.
In this article, we will discuss how a solo (or one person) plan works. We will also discuss some of the advantages and disadvantages. So let’s get started!
Table of contents
A Single Participant Plan
401k plans are common to many self employed business owners. Contributions are made by the employee and the business can add a profit-sharing contribution. A tax deduction is available for both contributions.
However, a one person defined benefit plan works differently. Contributions are made by the employer to the participant’s retirement account based on calculations by an actuary. A one person defined benefit plan provides a lump sum amount or a specified annuity payment at retirement age.
How a Solo Defined Benefit Plan Works
Employer provides plan documents offering an interest contribution to be made to an employee account on top of the regular pay credit contributions. Some prefer this form due to less involvement while others prefer dictating their own way to invest, which is either a positive or negative aspect of a defined benefit plan based on your preferences.
Defined benefit plans thus have a steady growth free from stock market fluctuations. Interest contributions range from 4% to 5% annually of the contributed amount. Here you will find a few examples.
Investment firms assist business owners to manage defined benefit plan funds. These funds are typically invested in mutual funds and other liquid investments. In some cases, life insurance can be utilized.
The investment firm ensures the objectives are achieved. Defined benefit plans are advantageous to employees; they have little or no involvement in the investments while the employer is tasked with everything including risks involved with the investments.
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Advantages under a solo defined benefit plan include:
- A full tax deduction for amounts contributed.
- The ability to combine with defined contribution plans like 401ks.
- Contributions are generally based on a percentage of compensation.
- The annual rate of return is based on actual returns or on an interest rate credit that is specified in the plan document.
- Solo pensions are great for 1099 independent contractors.
- IRS has established rules relating to solo defined benefit plan contribution limits. Because of the tax advantages, individuals demand higher contributions.
A One Person Plan for Independent Contractors
Defined benefit plans do not set specific limits (see our dummies post). Every employee has a different limit based on certain situations. Age is the main limit determinant, where older employees have higher limits as they near retirement compared to younger employees.
This allows them to recover their saving years within a short period of time. Length of service, with the company, the position held and job responsibilities also determine the contribution limits.
A solo defined benefit plan allows an individual to take advantage of a combination of both 401k and profit sharing plans. These two plans have varying contribution limits subject to yearly set limits and rules.
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By combining the three plans, a participant enjoys a higher aggregate annual limit. This is a huge advantage for heavy retirement saving as well as tax deductions for 1099 contractors.
Who is a Good Candidate?
Professional service businesses are the best candidates for a one person defined benefit plan. They have less overhead and higher earnings power which puts them in a good position as compared to other businesses. Some professional service businesses that could take advantage of a one person defined benefit plan include:
- Attorneys and law firms
- Accountants and CPAs
Historically, law firms and medical practitioners have been the best candidates of a one person defined benefit plan. Generally, it is because of their high incomes and higher solo defined benefit plan contribution limits.
1099 Rules on Withdrawals and Rollovers
The goal of a single participant benefit plan (or solo pension) is to provide a secure retirement. Early withdrawals before retirement are subject to penalties. Withdrawal are allowed if the entire amount in the account is withdrawn. These amounts are taxed as ordinary income.
Any withdrawal made less than the account balance has a 10% penalty on top of taxes on the amount withdrawn. Just make sure that you discuss any withdrawals with a defined benefit plan TPA.
How to structure a solo or one person defined benefit plan:
- Verify that you have no qualifying or eligible employees
There are strict eligibility rules that you must follow. Remember that you can exclude employees that work less than 1,000 hours, are age 21 (or younger) and who started work during the year. Ensure that you understand whether or no you have qualifying employees. If you do, you will have to make a contribution for them.
- Determine your proper funding
Plans can have a flexible design. In fact, you can do a prior service adjustment in year one to get the initial funding higher. You also can set up a plan to allow for a first year flat dollar amount. Then in subsequent years it can vary depending on your W2 compensation and other factors.
- Sign the plan document
Your administrator will draft the plan document for you. They can also customize it based on your business requirements and the number of employees you have. Make sure you review it with your CPA and financial advisor to ensure it meets your funding requirements.
- Determine who will be your custodian
You will be the trustee of your own plan, so you can manage your own investments. But you still will need to locate an investment custodian so you can pick your investments based on the plan profile. Most plans can be used with a variety of custodians, so do your due diligence.
- Fund the plan by the deadline
Thankfully, you have plenty of time to get your plan funded. Remember to allow yourself time to set up the plan, schedule an onboarding call, and get it funded by the date you file your tax return. Don’t miss the deadline!
|Eligible for 100% tax deduction||Permanent plan design|
|Custom plan design||High plan costs|
|Flexible funding ranges||Conservative investments|
|Large contributions||Required contributions|
Solo Defined Benefit Plan Contribution Limits
In case of a change in career or job, defined benefit plans can be rolled over to an IRA for continuity in contribution. A rollover can also occur when a company terminates a plan based on fundamental business change.