The design of a defined benefit plan for a small business owner with no W-2 employees is simplified and we provide this information here.
The design of a defined benefit plan is more complicated when a business consists of an owner with W-2 employees or multiple partners/owners with W-2 employees. Frequently the goal of the owners and partners is to maximize contributions to themselves and to key employees while minimizing contributions to rank and file employees and still satisfy IRS rules. Contributions to a defined benefit plan are 100% funded by the company and are made to owners and to W-2 employees who work more than 1,000 hours in a calendar year. The design of the defined benefit plan is influenced by the goals of the owners and partners and also by the demographics of the company. Employees with high W-2 salaries and those who are older receive larger contributions. Often times a defined benefit plan will be combined with a 401k plan and a profit sharing plan to maximize contributions.
In 2020 owners and employees can make voluntary 401k contributions up to $19,500 or $26,000 for those age 50 and older. Frequently the employer will make a safe harbor 401k matching contribution according to the Basic, Enhanced or Non-Elective formulas to avoid non-discrimination testing so the owners and highly compensated employees can contribute the 401k contribution limit.
The profit sharing contribution is made by the owner(s) and partners. Adding a profit sharing plan to a defined benefit plan has potential advantages. By making the required contribution to a profit sharing plan to select W-2 employees the business owner(s) can potentially avoid having to make a defined benefit plan contribution, therefore maximizing the contributions to the owner(s) and key employees. The calculation of the required contribution for the profit sharing and defined benefit plan is performed by an actuary and requires a census. The census will include the employees and owners date of birth, W-2 salary, title, percentage of ownership and hire date.
Fully Insured Defined Benefit Plan
This plan may be well suited if there are one or two owners with a limited number of W-2 employees. Also may be a good option when the only W-2 employees are family members. Annual contributions to owners and eligible employees can potentially be higher than a traditional or cash balance plan. Contributions are made to an annuity and earn a guaranteed minimum interest rate and account values at retirement (age 62 or 65) are guaranteed by an insurance company.
Traditional Defined Benefit Plan
This plan may be well suited when the business owner(s) would like to invest the defined benefit plan in stocks, bonds, mutual funds and ETFs. The owners are responsible for fully funding the plan regardless of actual performance. Annual funding requirements are influenced by account volatility because the calculations are based on account values on December 31 of each year. The annual required contribution can potentially increase or decrease each year depending on account performance. Investments in the plan fluctuate and must be certified by an actuary each year.
Cash Balance Defined Benefit Plan
This plan may be well suited for partnerships and professional groups with multiple owners with varying percentages of ownership and compensation. As a result they are popular with law firms, dental practices and medical practices. Owners and employees are divided into groups or tiers by their position with each group receiving a different level of contribution. Frequently the goal is to maximize contributions to the owners and partners and to key employees while minimizing contributions to rank and file employees. The plan is designed with a fixed annual crediting rate, 3% for example. The owners and partners are responsible for crediting each account at the pre-determined rate regardless of actual account returns. Investments are typically safe, ideally earning a rate similar to the crediting rate and have low volatility. Annual contribution 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.