What is a Defined Benefit Plan?
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. Factors such as a client's age, income, length of time before retirement and rate of return of the investment portfolio impact the required annual contribution amount. On an annual basis, an actuary makes calculations to determine the amount that needs to be contributed into the plan to ensure the target retirement income goal is reached.
How much can I contribute into a Defined Benefit Plan?
The amount that can be contributed annually is based on factors such as a client's age, income, length of time before retirement and rate of return of the investment portfolio. In 2023 the annual benefit payable at retirement can be as high as $265,000 per year. As a result, annual contributions into a defined benefit plan can be even larger than $265,000 in some cases in order to meet that level of retirement income target. On an annual basis, an actuary makes calculations to determine the amount that needs to be contributed into the plan.
Here is a case study of married doctors who set up a defined benefit plan. They were both self employed with $950,000 of combined income. They were able to contribute a total of $293,748.
What is the IRS annual compensation limit for a Defined Benefit Plan?
In 2023 the IRS annual compensation maximum limit used to calculate the defined benefit contribution is $265,000.
What type of businesses are eligible for a Defined Benefit Plan?
Sole proprietorships, S and C corporations, LLCs and partnerships are eligible.
Who makes the contributions in a Defined Benefit Plan?
100% of the contributions are made by the employer. Contributions are generally 100% tax deductible (within IRS limits).
Small business owners with employees must make contributions for eligible employees. Employees do not contribute to a defined benefit plan. When a defined benefit plan is setup eligibility requirements can be established such as 1 year and 1000 hours of service so part time employees that do not meet the requirement are not included in the plan.
I am the owner of multiple businesses. Do I have to cover employees in both businesses?
Yes, you may need to include employees in both businesses since you may be considered a "controlled group" or an “affiliated service group”.
Are annual contributions mandatory?
Yes. A contribution is required each year to fund the predetermined retirement benefit amount at the specified future retirement date. The retirement benefit amount and retirement date are determined when the defined benefit plan is established.
Can a Defined Benefit Plan be amended if my income changes?
Yes. In general, you can amend the plan to increase or decrease the benefit formula. By amending the plan it will increase or decrease the annual contributions that need to be made. It may be viewed as abusive by the IRS if too many amendments are made. As a result, amendments should be infrequent. Here is a case study of an attorney who setup a defined benefit plan with the intent to maximize annual contributions in year 1 due to unusually high income and then amend the plan in year 2 to reflect his normal income.
What happens if I decide I want to retire and stop working prior to my Defined Benefit Plans specified retirement date?
In general, you can amend your plan and change the age of your planned retirement date. Also, if you want to work longer than you anticipated you may be able to amend your plan to extend your retirement date.
When can I retire and stop making contributions to the Defined Benefit Plan?
Generally the plan is designed to have a retirement age of 62 or age 65 and is expected to be maintained at least 3 years. You can terminate the plan prior to retirement date if your circumstances should change. However, the actuary will run calculations and if there is a shortfall then additional contributions may be necessary before the plan is terminated. When the plan is terminated the lump sum value can be rolled over to an IRA.
When must a Defined Benefit Plan be established?
- Sole proprietorship, partnership or a LLC taxed as a sole proprietorship - A defined benefit plan must be established by the individual's personal tax filing deadline, generally April 15th or October 15 if an extension was filed.
- S corporation, C corporation or a LLC taxed as a corporation - A defined benefit plan must be established by the corporate tax filing deadline, generally March 15th or September 15 if an extension was filed.
What is the deadline for contributions to take a deduction for the current tax year?
Contributions must be made by your business's tax filing deadline for the current tax year (plus extensions), but no later than September 15th.
Can a 401k and a Profit Sharing Plan be added to a Defined Benefit Plan?
Yes. You can potentially add a 401k and profit sharing plan to a defined benefit plan. Adding a 401k and profit sharing plan can increase annual contributions and tax deductions.
Are loans or hardship withdrawals allowed?
Hardship withdrawals are not permitted. Participant loans are available if you elect to have this feature when you adopt the plan. If you receive a loan from the plan, it may increase the annual contribution you are required to make into the plan. Loans are not permitted in a fully insured defined benefit plan.
What happens at retirement?
At retirement, at reaching age 62, or upon plan termination, IRS rules generally allow you to roll the assets into an IRA. In an IRA assets continue to grow tax-deferred. Another option is to purchase an annuity and start receiving periodic distributions. Income taxes must be paid when distributions are received.
Do you have any specific case studies of clients who have benefited from establishing a Defined Benefit Plan?
Here are case studies providing real examples.
