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So what even is a defined benefit plan?
The defined benefit plan is a lesser-known retirement savings strategy that many business owners can implement in their business, in addition to the 401(k) plan, which is a type of defined contribution plan. Defined benefit plans are more complex than a traditional defined contribution plan, but a small investment of time will determine whether you qualify for a defined benefit plan and if so, how much tax savings you will receive. The goal of this article is to educate you on the basics of these plans and provide enough information to help you decide if a defined benefit plan is not only beneficial to you, but also serve as a recruiting and retention tool for your employees as well.
What is the difference between a defined-contribution plan and a defined benefit plan?
If you’re a business owner, you know that defined contribution plans are very common, and the most popular defined contribution plan is the 401(k). As of June 30, 2021 401(k) plans held an estimated $7.3 trillion in assets and represent nearly one-fifth of the $37.2 trillion US retirement market, which includes employer-sponsored retirement plans, both defined benefit and defined contribution plans with public and private-sector employees.
Years ago, defined benefit plans were very common among large corporations and most retirees who worked for a large company retired with a lifetime pension. However, defined benefit plans are less common in large corporations today and they more commonly offered by private business owners whose businesses produce a high level of consistent income. Defined benefit plans are unique because they don’t necessarily have a cap on how much you can contribute. Unlike defined benefit plans, contributions to defined contribution plans, such as a 401(k)’s, are capped. 2022 contribution limits for elective deferrals in 401(k)’s are only $20,500, with a catch-up contribution of $6,500 if you’re over 50.
The limit on total annual contributions to a defined contribution plan including elective deferrals, employee contributions, employer matching, and discretionary contributions is limited to $61,000 for 2022. So, if you’re a high wage earner a defined benefit plan may offer the ability to contribute a much larger amount each year in addition to your 401(k), and with that, you’ll receive a much greater tax deduction than simply maxing out a defined contribution plan. Defined benefit plans grow tax-deferred just like defined contribution plans, but with a defined benefit plan the goal is to solve for a future retirement benefit, at a pre-defined retirement age, thus establishing how much you can contribute to your plan for the current year.
Are defined benefit plans tax deductible?
As mentioned above, defined benefit plans are tax deductible. In fact, the higher your tax rate, both federal and state combined, the more likely it is that a defined benefit plan could benefit you because each dollar protected from being taxed is more valuable. At BWM we can assess your current income, business structure, and potential future business earnings to determine whether a defined benefit plan may make sense. At our firm we focus heavily on the client’s financial plan. Tax deductions you receive from a defined benefit plan can be very significant, and utilizing one of the industry’s best software tools, our team can run a side-by-side comparison for you, with, or without a defined benefit plan to determine the impact implementing one of these plans can have on your retirement goals. By implementing a defined benefit plan, and generating a large tax deduction each year, you could be closer to achieving your retirement goals than you once thought.
How is a defined benefit plan paid out?
When you retire, defined plans can be paid out in two different ways. By far, the most common method is lump sum. When you retire, you simply transfer your defined benefit plan to a rollover IRA in your name There are no taxes incurred to roll your defined benefit plan to an IRA. However, it’s extremely important that if you select your defined benefit plan to be paid directly to you, that you roll it over to an IRA within 60 days; otherwise, your rollover will become immediately taxable.
Our team at BWM is well-versed on this process as we help clients with their rollovers throughout the year and ensure transfers are executed seamlessly to avoid any unnecessary expenses. The second method in which a defined benefit plan can be paid out is by annuitization. This method was more commonly used by employees who retired from large corporations, but is rarely used today because clients prefer to have control over their money and have access to their funds for any purpose.
Annuitization converts the balance of your defined benefit plan to a series of periodic income payments. We assist our clients in deciding on the best distribution method for their defined benefit plans and can illustrate which method fits best with your retirement goals.
Who is a defined benefit plan best for?
If you’re a business owner, between 45-65 years old making consistent income between $500K-$2Million+ per year, a defined benefit plan could be a good solution for you. For those making less than $500K per year, typically there is not enough excess cash flow to fully take advantage of a defined benefit plan. The ideal candidate for a plan is a business owner that has plenty of excess cash and they are not using the cash flow to fund their business, or their lifestyle.
Who is eligible for a defined benefit plan?
Also, if you don’t know how many employees will be working in your business over the next few years, meaning it could be 5 people, or 50, a defined benefit plan is not a good fit. That’s not to say that a growing business couldn’t be an ideal candidate for a defined benefit plan, but a business that is stable, and the owner knows where’s it’s been and where it’s going, is an ideal profile for a defined benefit plan. In addition to the business owner, the employees are also eligible for contributions to their plan, paid by the business owner, based on their age and income.
In evaluating whether a plan is beneficial to open for the business owner, a calculation must be made that incorporates the amount of contribution, and the tax deduction that the business owner will receive based on the maximum contribution they can make to the plan and the cost for making plan contributions to the employees. Ultimately, if the owner’s tax deduction is significant in comparison to the employee funding costs, a plan could make sense. For those making over $2Million per year the tax deduction from the defined benefit plan may not be as impactful to your bottom line, but it still could be a valuable savings tool. Our team can assist you in determining if that is the case by working with your CPA, and a qualified third-party administrator (TPA) which we will discuss in more detail below.
What is a cash balance defined benefit pension plan?
A traditional defined benefit plan is typically recommended for a husband and wife who own a business and the assets in the defined benefit plan are ultimately distributed back to the same household.
However, there’s another type of defined benefit plan, called the cash balance plan. These plans are used with unrelated business owners and/or employees where the defined benefit plan assets are not going back to the same household. With a cash balance plan, each participant has a hypothetical account balance, similar to how each employee maintains their own 401(k) balance, although the assets are managed in one account. In working with our team at BWM we help clients determine whether a cash balance plan or traditional defined benefit plan makes the most sense. For example, if two owners of a business split profits 50/50 and the business is structured as an S-Corp, you want to make sure you can split the defined benefit plan proceeds 50/50 when the owners pull money out of the plan, and with the cash balance plan that can be accomplished, whereas a traditional defined benefit plan the account balances of two owners will never be the same.
How much can you contribute to a defined benefit plan?
Contributions to a defined benefit plan are based your age, income level, and years the company has been in business. The contribution is based on the annual dollar amount that is required to pay out an annual benefit during retirement. The contributions are typically calculated by an actuary who usually works at a third-party administrator (TPA). For 2022, the annual benefit cannot exceed the lesser of 100% of the participant’s average compensation over their highest 3 consecutive calendar years, or $245,000.
Or another way to view contributions is that an amount as high as $2.9 million can be paid to the business owner at age 62. Typically, a defined benefit plan is funded over 10 years. However, if a participant is older and much closer to retirement, they could fund a higher amount each year to reach the maximum benefit limit, over a period of 5 years. As part of a client’s financial plan, we will work with you to determine the impact of implementing a cash balance plan, particularly if you already have a 401(k), as your annual retirement savings amount will rise considerably.
How do I start a defined benefit plan?
Every defined benefit or cash balance plan needs to be administered by a professional third-party administrator (TPA). At BWM we work very closely with TPA, Premier Plan Consultants in San Diego. The initial step is to obtain a census that lists all owners and employees, their age, income, and hire date. Premier Plan Consultants will then determine how much the owner(s) can contribute each year between 401(k) and additional contributions to a defined benefit or cash balance plan, factoring in the additional cost to the owner(s) to make benefit plan contributions to their employees.
In general, if over 85% of all contributions (combined 401(k) match, and defined benefit plan) go back to the owner, a plan is worth considering. Each year, an actuary who works at the TPA will calculate the annual contribution that is allowed and the TPA conducts all testing requirements to ensure your plan is following IRS regulations.
What can you invest in with a defined benefit plan?
Defined benefit plans should be managed conservatively. How you invest your defined benefit plan is extremely important and at BWM we are experienced at managing these plans for clients. Having the proper asset allocation is critical and by working closely with Premier Plan Consultants we determine a conservative allocation comprising of equities, fixed income securities, and alternative investments that will deliver a consistent, low to mid-single digit return.
Typically, a defined benefit plan is implemented as a tax deduction play with the goal to seek consistent portfolio returns of around 5%. If the investment return significantly exceeds 5% the plan can become overfunded and a 50% excise tax will be due on the overfunded amount. However, this is only an issue when the plan is close to being shut down. For example, a plan can be intentionally overfunded during the first 5 years because the TPA knows that the client’s income will drop over the following 5 years. On the other hand, if the investment portfolio is too risky and significant losses occur, the business owner will have to fund additional cash into the plan. We discourage clients from funding their plans with cyclical assets, as prices can quickly rise, or fall, causing the plan to become overfunded or underfunded, and liquidity can become an issue in a recessionary environment.
How much does it cost to setup a defined benefit plan?
In our experience, it generally costs about $2,000-$4,000 for a TPA set up a defined benefit plan. Annual TPA costs, will range between $2,000-$5,000. By working with an experienced TPA like Premier Plan Consultants, we ensure our clients not only pay a reasonable fee but receive the same excellent service our clients have come to expect from BWM.
If you’d like more information on how a defined benefit might help with reducing your taxable income, or clarity on how it could help you retire sooner, please reach out to us.