What is the best strategy to 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 or one person 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.
|Tax-deductible funding||IRS permanency rules|
|High $100k plus contributions||Required annual contributions|
|Funding options||Conservative investments (5% rate)|
|Custom-tailored design||Expensive fee schedule|
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 (One Person)
- How a Solo Defined Benefit Plan Works
- A One Person Plan for Independent Contractors
- Who is a Good Candidate?
- Defined benefit plan formula and calculation
- Best tax advantages
- What about the pay credits?
- 1099 Rules on Withdrawals and Rollovers
- How to best structure a solo or one person defined benefit plan
- Solo Defined Benefit Plan Contribution Limits
A Single Participant Plan (One Person)
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 best 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.
Defined benefit plan formula and calculation
Depending on the plan structure, you can choose a traditional defined benefit or cash balance plan. For each year eligible employees participate, they receive a benefit under the following formula:
(Salary x Pay Credit Rate) + (Account Balance x Interest Crediting Rate)
= Employee Accrued Benefit
Interest credits are added to the cash balance account. The rate of interest credited can vary annually, but the method for determining and allocating it must be specified in the plan document.
The interest rate allocated can be fixed or tied to a specified index, like the Treasury note rate. Depending on plan design, you can tie the interest rate to the actual plan investment return. However, that can create volatile results with wide swings in annual contributions.
Best tax advantages
Not only do cash balance plans offer exceptional retirement savings, but they also provide significant tax benefits. This is true for the contribution amounts and the earnings on those contributions.
Now, this is just one cash balance plan example. Each client’s situation is different. But the goal is to ensure you listen carefully to your client and craft a retirement plan design that suits their needs.
If you have a cash balance plan, you must satisfy the plan’s minimum funding requirements each year. But determining the funding amount can be complicated and requires the help of an actuary. Then the contribution needs to be made by the cash balance plan funding deadline.
As a general rule, plan contributions are applied to the year they are made. However, you can apply them to the prior tax year if all of the following requirements are met:
- The contributions are made by the due date of your income tax return for the prior year (plus any applicable extensions);
- The plan document was established by the end of the prior year; and
- As a policy, the plan treats the contributions as if they were received on the last day of the prior year.
In addition to the above requirements, you must do either of the following:
- Provide a written statement to the plan administrator or the trustee that the contribution will apply to the prior year; or
- Deduct the contributions on the applicable income tax return for the prior year.
What about the pay credits?
A variety of pay credit rates can be utilized. Most plan structures will use a percentage of compensation, but the actuary can also use a flat dollar amount.
The benefit calculation must be definitely determinable. As such, the plan document must specify the pay credits. If the company wants to change the pay credit, it is allowed. However, you are not able to reduce any prior earned accrued benefit.
Examples of pay credits or pay formulas can include:
- $10,000 for each participant
- 6% of compensation for each participant
- $2,000 per service year
Generally, the actuary applies the pay credit to the current year’s compensation at year-end. The plan will define eligible compensation and can include or exclude bonuses.
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 best structure a solo or one person defined benefit plan
Here are the 5 steps to structuring a 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. The best 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.
6 thoughts on “Solo Defined Benefit Plan Contribution Limit + Best Formula [+ IRS Rules]”
I have a couple employees but they are part-time. Do I have to include them?
Hi Frank – if they work over 1,000 hours then you will need to include them (as a general rule) in the plan. But you can exclude up to 60% of employees based on discrimination testing. But if they work less than 1,000 you should be fine.
If I’m 35 making 1m/year how much could I contribute to a Personal Defined Benefit Plan (would be for me & the wife, only I’m working)?
Hi Vincent – you absolutely should consider a plan. A 35 year old could get up $200k into a plan in year one. Reach out to us and we would be glad to run an illustration for you!
Thank you for the article. Very informative. As an independent contractor do you know if the contribution to the defined benefit plan will be listed as a pension business expense on Schedule C and reduce net income and self employment tax as well?
Hi Matt – for a solo plan with no other employees, a contribution to a defined benefit plan is included as an adjustment to income and is NOT included on the Schedule C. So it will save you on federal and state income taxes but NOT self-employment tax. Here is an article on the issue: https://www.emparion.com/deduct-cash-balance-plan-contributions-tax-return