The Defined Benefit Plan
What if there were a retirement plan that allowed for very large tax-deductible contributions of $100,000 to $250,000+ per year? What if that deduction could potentially double if your spouse was an employee in your business? What if this great retirement plan could be added in addition to your 401(k) Plan?
Sound too good to be true? You are in luck. This is all possible if you have a Defined Benefit plan, which is also known as a pension. If you have a a defined benefit plan, you can have access to these types of large deductions. Wondering why you have never heard of this type of plan? Me too. These plans are not new. They have been around longer than 401k plans. So why have your financial advisors not told you about this?
In 1975 the first private pension plan was established in the US by American Express. Many other companies followed by establishing their own pensions as well. However, in the past few decades businesses have been trending away from using pension plans, which puts more of the burden of saving for retirement on the shoulders of the employees. While large companies are moving away from this great retirement plan, smaller companies, especially the ones employing high income earning professionals, can still use this great plan to put away a large amount of money for retirement pre-tax.
If you are aware of how 401k plans work, the defined benefit plan is similar. There are some differences, but we will discussed this more below.
What is a Defined Benefit Plan?
A Defined Benefit Plan is a type of retirement Plan just like a 401(k), Profit Sharing, SEP or SIMPLE.
Defined Benefit Plans, like other retirement Plans, qualify for significant tax deferral. Most notably, retirement deposits are tax-deductible and investment gains are not taxed until distribution.
However, Defined Benefit Plans are fundamentally different from your 401k. Many retirement vehicles can be classified under the title of Defined Contribution Plan, rather than Defined Benefit Plans. Confused yet?
What is important is that both allow you to put away money for your retirement. The difference primarily is how the retirement benefit is determined. A Defined Contribution plan focuses more on the amount of the contribution, whereas the benefit is unknown. The Defined Benefit Plan is more focused on the benefit portion.
In a Defined Contribution Plan, the retirement benefit is unknown until retirement. The retirement payout will depend on a number of factors, including the amount and timing of contributions and investment growth.
In a Defined Benefit Plan, you pre-define the retirement benefit, then work backwards to determine how much you need to contribute each year to pay that benefit.
How Could a Defined Benefit Plan Help You?
Defined Benefit Plans allow for massive, tax-deductible retirement contributions. In determining how much you can contribute to a Defined Benefit Plan, age is a central factor.
Take for example, a high income business owner who is age 50 and has very little retirement savings. Assume, he would like to have the maximum retirement payout when he retires at age 62. In such a scenario, he could fund towards a maximum payout of nearly $3 million, allowing for annual contributions of approximately $200,000 per year for 12 years.
Compare that to a younger business owner. Lets look at a second example of a 35-year old business owner, they could contribute roughly $90,000 per year for 10 years into a Defined Benefit Plan. The contributions allowed would be lower because there is more time until the benefit is realized for retirement.
If you compare these numbers to your 401(k) plan, age is only a small factor in the contribution limit. In 2019, the 401(k) limit is only $19,000 per person. If you are 50 or older, the limit is increased to $25,000. While these limits may be adequate if you begin contributing at an early age, if you make small or delayed contributions, your 401(k) balance may be inadequate.
How much can you deduct in a Defined Benefit Plan? You can use a Defined Benefit Plan calculator to get an estimate.
Is the Defined Benefit Contribution Fixed?
The short answer is no. They are not fixed. You have a wide range of flexibility to determine the amount of funds you want to contribute to your defined benefit plan.
While the contributions you make are not discretionary and generally are required each year, you do have a lot of flexibility when funding your Defined Benefit Plan. The minimum and maximum contributions to fund your benefit are determined each year by an actuary. Often, the contribution range can be quite large. The minimum contribution reflects a 7-year amortization of unfunded benefits while the maximum contribution allows funding at 150% of the benefits. In addition, in some cases, excess contributions can be stored as “credits” to satisfy future contribution requirements. These “credits” increase contribution flexibility.
What If I Can’t Make Required Contributions?
If you make contributions early enough in the year, the Plan can be amended to reduce benefits. This may reduce the required contribution. If you still cannot make a required contribution, unpaid contributions are subject to a 10% per year excise tax.
That said, the risk of unpaid contributions can be reduced by over-funding the Defined Benefit Plan in strong years and investing conservatively. In years where you earn less, this over-funding can allow you to balance the plan.
What If My Spouse is an Employee in the Business?
If your spouse is an employee, you can provide a Defined Benefit to both you and your spouse. In the previous example, that may mean a maximum payout of nearly $6 million at age 62 (about $3 million each) and annual contributions of approximately $400,000 per year.
Still confused about the difference between a 401k and this defined benefit plan?
$400,000 annual contributions vs $38,000 for a married couple. that more than 10x the contributions made each year. Not a bad way to play catch up for your retirement savings.
Can I have a 401(k) Plan Also?
Yes. The employer can sponsor both a Defined Benefit and 401(k) Plan. In addition to the Defined Benefit, you are permitted to max out your 401(k) contributions as an employee. An employer contribution also can be provided to the 401k plan, but it must be limited to 6% of earned income (definition of earned income depends on taxation of entity).
Does a Defined Benefit Plan Make Sense if I Have Employees?
It depends on how old you are relative to your employees, how many employees you have and how much they’re paid.
Rule of Thumb For Employers
As a rule of thumb, if you are a business owner, and you want to maximize your Defined Benefit contribution, it will cost 8-10% of staff payroll (actual cost will depend on the factors discussed). To determine if a Defined Benefit Plan makes sense, you can compare the “value” of the tax deduction with the staff benefit cost.
For example, if a business owner, with a combined tax rate of 40% contributes $200,000 per year to his Defined Benefit and has 10 employees with a staff payroll of $400,000, there would be substantial value:
- Owner DB Plan deduction: $200,000
- Staff cost: $40,000 (10% of staff payroll)
- Total deduction: $240,000
- Tax reduction: $96,000 (40% of Item 3)
- Net DB Plan “value”: $56,000 (Item 4 – Item 2)
Lets look at a second example where the business owner only contributed $100,000 for that level of payroll (or had a higher staff payroll),
- Owner DB Plan deduction: $100,000
- Staff cost: $40,000 (10% of staff payroll)
- Total deduction: $140,000
- Tax reduction: $56,000 (40% of Item 3)
- Net DB Plan “value”: $16,000 (Item 4 – Item 2)
In this case it may make sense, but it would not be significant. To see if a Defined Benefit Plan makes sense, it’s best to talk with an expert who understands defined benefit plans, like a pension actuary or a third party administrator (“TPA”).
When Can I Access the Funds in a Defined Benefit Plan?
Funds can be accessed when the Plan is terminated, or you separate from service.
It is also possible to request for a loan from your Defined Benefit Plan (similar to your 401(k) plan), however it is not recommended in most cases.
How Long Must the Defined Benefit Plan Be Open?
To avoid disallowed deductions, it is suggested that you have the Defined Benefit Plan for at least 5 years, although 3 years may be defensible. Using a Defined Benefit Plan for a 1-year “tax play” is not recommended.
Is a Defined Benefit Plan Right for Me?
If you are at least 35-years old, self-employed, or own a business and you would like to save more than your current retirement Plan allows, you should consider a Defined Benefit Plan. If you want to see if it is a good fit. You should talk to your financial professional to run some estimates. Many financial advisors are not familiar with this type of plan. If you want to learn more, we work with a number of TPAs and actuaries who can help determine the best fit for your company. If you are a do-it-yourselfer, as they say on TV, "don't try this at home."
How Do I Set Up a Defined Benefit Plan?
First, you need to find a qualified Defined Benefit practitioner, such as a pension actuary or Defined Benefit third-party administrator.
They will talk with you to understand your retirement and business objectives. Based on these goals, they will propose a Defined Benefit Plan design. The illustration will estimate how much you can deduct and your staff benefit costs, if applicable.
Assuming you move forward with the Defined Benefit Plan, the actuary will draft the plan document to specify the design in the Defined Benefit illustration. Once the plan document is signed by you, the plan is “adopted”. To receive a tax deduction for this year, the plan must be adopted by December 31st of this tax year.
After the plan is adopted, you have until September, 15th of the following year to fund the Defined Benefit Plan (assuming you have a calendar year based plan). To receive the deduction, the contribution cannot be made later than the filing of your business return.
One additional piece of important information. The Defined Benefit Plan will require annual government filings, actuarial calculations and the distribution of employee disclosures, if applicable. There are a lot of moving pieces, so make sure you are working with someone who knows how to set up and manage these types of plans.
What Is the Next Step?
If you want to learn more about Defined Benefit plans and how they can help you save more for your retirement, you can contact us. We work with people across the country to help them prepare for retirement. How can we help you?
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About Innovative Advisory Group: Innovative Advisory Group, LLC (IAG), an independent Registered Investment Advisory Firm, is bringing innovation to the wealth management industry by combining both traditional and alternative investments. IAG is unique in that they have an extensive understanding of the regulatory and financial considerations involved with alternative investments held in self directed IRAs and other retirement accounts. IAG advises clients on traditional investments, such as stocks, bonds, and mutual funds, as well as advising clients on alternative investments. IAG has a value-oriented approach to investing, which integrates specialized investment experience with extensive resources.
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About the author: Kirk Chisholm is a Wealth Manager and Principal at Innovative Advisory Group. His roles at IAG are co-chair of the Investment Committee and Head of the Traditional Investment Risk Management Group. His background and areas of focus are portfolio management and investment analysis in both the traditional and alternative investment markets. He received a BA degree in Economics from Trinity College in Hartford, CT.
Disclaimer: This article is intended solely for informational purposes only, and in no manner intended to solicit any product or service. The opinions in this article are exclusively of the author(s) and may or may not reflect all those who are employed, either directly or indirectly or affiliated with Innovative Advisory Group, LLC.