Defined benefit plans are retirement plans that can offer substantial tax deductible retirement contributions and significant future retirement income to qualified sole proprietors.
Depending on the age and income of the sole proprietor, annual contributions can be $100,000 to $200,000 or more. Loans may be permitted, however this may increase annual funding requirements.
What are the disadvantages of a Defined Benefit Plan?
More expensive to set up and to maintain. Mandatory annual funding requirements. Annual contributions are not discretionary like they are with an Individual 401k or SEP IRA.
What are the advantages of a Defined Benefit Plan?
The defined benefit plan is appropriate for sole proprietors who wish to make tax deductible contributions in excess of the maximum limits of the Individual 401k or SEP IRA. Defined benefit plans offer substantial tax deductible retirement contributions and significant future retirement income. Depending on your age and income the annual contribution to a defined benefit plan can be $100,000 to $200,000 or more.
Defined benefit plans have greater administrative fees and more rigid annual funding requirements, but may be ideal for sole proprietors who want to maximize their annual retirement plan contributions.
How does a Defined Benefit Plan work?
A defined benefit plan is a qualified retirement plan in which annual contributions are made to fund a chosen level of retirement income at a predetermined future retirement date. Contributions are made according to an actuarial formula to meet the target retirement income benefit. In 2020, the annual benefit payable at retirement can be as high as $230,000 per year. As a result, annual contributions into a defined benefit plan can be even larger than $230,000 in some cases in order to meet that level of retirement income target. There are a number of factors involved with this calculation.
How are the contributions into a Defined Benefit Plan determined?
Calculating the annual dollar amount that can be contributed requires a mathematical calculation performed by an actuary involving the following factors:
- Client's age - In general, the older the client then the larger the annual contribution that can be made into the plan.
- Client's income - The calculation is based on the average of the client's highest 3 years of income. The greater the income then the greater the annual contribution can be (up to certain limits). Depending on a client's income, the annual benefit payable at retirement can be as high as $230,000 per year in 2020.
- Planned retirement age - In general, at least 5 years from the year the plan is adopted.
- Investment performance - In the years after the defined benefit plan has been established an annual actuarial calculation is made based on the performance of the investments in the plan. The actual performance of the portfolio can impact the annual contribution amount that will need to be made so therefore having a portfolio that minimizes volatility is often prudent. When a defined benefit plan is established there is an rate of return assumption that is factored into the actuarial calculation to determine the annual contribution amount that is necessary in order to fund the future retirement income benefit. Each year the actual return of the portfolio will be compared to the rate of return assumption. When the portfolio's actual return is greater than rate of return assumption then there will be a smaller required annual contribution. Conversely, when the actual return is less than the rate of return assumption then the annual contribution will need to be increased to make up the shortfall. On an annual basis, an actuary makes calculations to determine the amount needed to be contributed into the plan to ensure the future target retirement income goal is reached.
Who is a good candidate for a Defined Benefit Plan?
Defined benefit plans may be ideal for sole proprietors with high earned NET income.
- In general age 40 or older. However, for high income earners a defined benefit plan can be appropriate by age 30.
- Clients who would like to maximize their retirement contributions in excess of the limits of the Individual 401k or SEP IRA.
- Clients with stable and predictable income (because of the large tax deductible funding commitment).
You are obligated to make annual contributions once your plan is established. Funding a defined benefit plan involves a commitment to invest significant amounts each year for the life of the plan. Within certain IRS limits, clients can decide how much of their current income they can comfortably afford to contribute to the plan, but once this annual contribution amount is established then funding a defined benefit plan is fairly rigid and must be made annually.
Defined benefit plans may be beneficial to older employees who may feel they are behind with their accumulated savings for retirement and need (or want) to make significant contributions to accumulate assets rapidly over a relatively short period of time.
Another scenario when a defined benefit plan may be a good choice is for a dual income household, with one spouse who is self employed and in the fortunate position of being able to live off of one income. As a result, they may be able to afford to make a significant retirement contribution into a defined benefit plan using the self employed spouse's income.
Another scenario when a defined benefit plan may be a good choice is for someone that is working full time with one employer and then has a separate self employed one person consulting business. This individual may be able to contribute a significant portion of their self employed income into a defined benefit plan.
A partial listing of some of the occupations that might qualify
- Financial Planners
- Graphic Designer
- Independent Corporate Director
- Independent Insurance Agent
- Manufacturer's Rep
- Mortgage Broker
- Real Estate Agent
- Software Developer
Can I contribute to a 401k plan and a Defined Benefit Plan?
Yes. In addition to having a Defined Benefit Plan a sole proprietor may be able to add a 401k salary deferral option to the Defined Benefit Plan. In 2020, a salary deferral may allow an additional $19,500 contribution ($26,000 if age 50 or older). Each year the funding of 401k salary deferral is completely discretionary. You can stop, decrease or increase your salary deferral contributions (up to the salary deferral limit). The Defined Benefit Plan annual contribution is mandatory and must be made annually.
It is important to note that contributions made to the employer’s 401k, 403b or Thrift Savings Plan will impact the salary deferral limit for the 401k contribution for the defined benefit plan. Contributions to the employer’s 401k, 403b or TSP count towards the 2020 401k salary deferral limit of $19,500 ($26,000 if age 50 or older). Contributions made into a 457 plan do not count towards the salary deferral limit.
In addition to a 401k salary deferral you can also make a Profit Sharing contribution which is limited to 6% of compensation, the 2020 limit is $17,100.
How much does a Defined Benefit Plan cost per year in administrative fees?
For a sole proprietor with no employees, the administrative cost of a defined benefit plan is $1,250 for the initial setup fee and $1,500 for the annual fee.
How much can I contribute to a Defined Benefit Plan?
Use this Defined Benefit Plan Calculator to see how much you could contribute based on your age and your income. Please note, the calculator is for illustrative purposes and is an estimate. Complete the form below to receive a proposal that is specifically created for you.