Defined Benefit Plans
Like a Cash Balance Plan, a traditional Defined Benefit Plan is a type of Pension Plan. Pension Plans offer the largest annual tax deductible contributions and savings for business owners in that, depending on an owner’s age and compensation, annual deductible contributions for an owner may be as high as $250,000 allowing up to $2.8 million in tax deferred savings in as little as 10 years.
A Defined Benefit Plan can greatly exceed the individual limits of a 401(k) Profit Sharing Plan because it promises to make annual payments to the participant starting at the retirement age specified in the plan document.
For example, consider an owner who is age 62, has participated in the Defined Benefit Plan for 10 years and has established an annual retirement benefit of $225,000 a year starting at age 62 (the maximum retirement benefit, indexed annually). By age 62 the plan would have needed to accumulate a lump sum amount of about $2.8 million to fund that $225,000 annual retirement benefit. So, if an owner starts a Defined Benefit Plan at age 53, the amount the employer would need to contribute would be approximately $250,000 each year to accumulate that $2.8 million lump sum amount by age 62.
A Pension Plan favors older owners because the closer an owner is to retirement age, the fewer years he or she has left to accumulate the amount needed to fund the promised benefit. Therefore, annual Pension Plan contributions for an older owner can be higher compared to younger participants.
To make sure the plan stays on track to fund the promised retirement benefits, each year an actuary calculates the amount the Employer sponsoring the plan must deposit based on actuarial funding methods. Benetech provides these actuarial services as part of our plan administration services for Defined Benefit Plans so you do not have to worry about finding a certified actuary to perform actuarial services – we provide it all.
Whether you’re a business owner with no employees (other than you and possibly your spouse) or an owner with multiple non-owner employees, a Defined Benefit Plan may provide you with large annual tax savings and retirement savings opportunity.
Characteristics of a Good Defined Benefit Candidate
Owner Age 40 or older. An older owner has fewer years to accumulate a lump sum retirement benefit compared to a younger owner. For this reason, an older owner needs a larger contribution annually to reach the lump sum amount by the plan’s retirement age.
Owner is older than about ½ of the non-owner employees. Discrimination testing for these plans is age sensitive, so younger employees are needed to optimize the annual contribution for the owner.
Owner expects stable income in future years. Annual contributions are required. Each year the actuary will calculate a minimum amount that must be contributed. While it may be possible to reduce required contributions for future years, the owner should select a contribution target he/she feels comfortable with for the first 3-5 years when establishing the plan.
Things to Consider Before Adopting a Defined Benefit Pension Plan.
Annual contributions are required. Each year the actuary will calculate a minimum contribution amount that must be deposited within 8 ½ months after the end of the plan year to avoid IRS penalties.
Investment return affects required contributions. The actuary uses IRS-stipulated interest rates to calculate contribution requirements each year. These rates vary each year, but are generally around 5%.
Actual rates of return in excess of these rates will tend to reduce future contribution requirements so as to not be in danger of accumulating more assets than allowed to fund the promised retirement benefits.
Conversely, actual rates of return less than these anticipated actuarial rates tend to increase future contribution requirements to stay on track to fund the promised retirement benefits.
Qualified Pension Plans are intended to be permanent. Typically you should expect to run the plan for a minimum of 5 years.