How are the annual contributions limits determined in a Defined Benefit Plan?
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 - High income earners can generally contribute more. The 2020 IRS annual compensation maximum limit used to calculate the defined benefit contribution is $230,000 and in 2019 the IRS compensation maximum limit is $225,000.
- Planned retirement age - In general, planned retirement age is at least 5 years from the year the plan is adopted. Age 62 or age 65 is typical.
- Investment performance
How does investment performance impact the required annual contributions for each type of Defined Benefit Plan?
With a fully insured defined benefit plan contributions are made to an annuity which earns an annual interest rate guaranteed by an insurance company. As a result, the fully insured plan has level annual contributions from plan inception to retirement. Annual contributions to a fully insured defined benefit plan may potentially be higher than a cash balance plan or traditional defined benefit plan. Higher annual contributions in a fully insured plan can be a benefit for business owners who are in a high tax bracket and want to maximize their tax deductions.
Typically the investments in a traditional defined benefit plan are stocks, bonds, mutual funds and ETFs. These investments do not earn a guaranteed interest rate and the portfolio will fluctuate based on market performance. Each year the actuary uses the account value on December 31st in the calculation. As a result, the performance of the portfolio can impact the annual contribution amount that will need to be made. The owners and partners are responsible for crediting each participant in the plan regardless of actual portfolio returns. As a result having a portfolio that minimizes volatility is often prudent.
When a traditional defined benefit plan is established there is an rate of return assumption (approximately 5% to 5.5%) 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.
Cash Balance Plan
The cash balance plan is designed with a fixed annual crediting rate. The owners and partners are responsible for annually crediting each participant in the plan at the pre-determined rate regardless of actual portfolio returns. As a result investments are typically safe, ideally earning a rate similar to the crediting rate and have low volatility. Annual contributions can be made into a guaranteed fixed annuity if the owners and partners want the insurance company to bear the investment risk. The plan is certified by an actuary each year.
I am self employed with no employees and in 2020 will have $230,000 of net income for my sole proprietorship. Can I contribute $230,000 to my Defined Benefit Plan?
Calculating the annual dollar amount that can be contributed to a Defined Benefit Plan requires a mathematical calculation performed by an actuary. The amount that you could contribute may be more or less than $230,000 depending on your age.
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.
I am self employed, age 45 with no employees and I had an income windfall this year and anticipate of $250,000 of net income for my sole proprietorship. I usually earn $50,000 in net income. Should I setup a Defined Benefit Plan?
No probably not. In order for a defined benefit plan to be a good option, the business owner should feel confident about being able to make the required annual contribution for 3 years. For example, a Defined Benefit Plan is not the correct choice for someone that anticipates an income windfall in one year, but then is unsure about being able to make the required annual contribution in future years. A self employed individual in this scenario may want to setup an Individual 401k instead due to the annual contribution flexibility.
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 a defined benefit plan for an attorney age 60 with typical income of $150,000 per year who won a big case and earned $600,000 in the current year. The defined benefit plan was designed to maximize the contributions in the current year with the intent to amend the plan in Year 2 to reflect $150,000 of income for future years.
The calculations of how much can be contributed to a Defined Benefit Plan can be a little tricky to understand, but contact us and we would be happy to answer your questions and run a customized Defined Benefit Plan proposal for you based on your income. Also, utilize the Defined Benefit Calculator to give you an idea of how much you could contribute. Keep in mind, the calculator is for illustrative purposes and is an estimate. There are certain plan design options such as adding a 401k and profit sharing plan to the Defined Benefit Plan that can potentially increase the annual contribution amounts beyond what this calculator is showing.