Defined Benefit Plans for a one person business, an owner and spouse business or a business with multiple owners with no W-2 employees

Self employed individuals have the luxury of being able to create their own personal defined benefit plan and potentially contribute up to $100,000 to $200,000 or more annually. These plans are ideal for self employed business owners who want to reduce their taxes and maximize their tax deductions and retirement contributions. Often times a defined benefit plan will be combined with a 401k plan and a profit sharing plan to maximize contributions.

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. Traditional defined benefit and cash balance plans are required by IRS rules to be certified by an actuary each year. Fully insured defined benefit plans have guaranteed account values so they don’t need to be certified by an actuary each year.

Fully Insured Defined Benefit Plan

  • Annual contributions are based on an estimate of your self employed income for your current 2018 tax year. A good feature for newly self employed individuals and for those who have higher income in their current tax year than in previous years.
  • Contributions are made to an annuity which earns an annual interest rate guaranteed by an insurance company.
  • Your account value at retirement (age 62 or 65) is guaranteed by an insurance company.
  • Fixed interest rate and S&P 500 Index annuity as investment options.
  • The business owner can potentially buy life insurance in the plan. Annual insurance premiums are taxed deductible.
  • Annual contributions to a fully insured defined benefit plan may be higher than a cash balance plan or traditional defined benefit plan.
  • Administrative fees are generally less expensive. The investments in a fully insured defined benefit are guaranteed, IRS rules do not require the plan to be certified by an actuary each year.
  • $0 Setup Fee and $1,000 Annual Fee

Traditional Defined Benefit Plan

  • Annual contributions are based on a client’s highest 3 years of income.
  • Difficult to understand because the benefit is not based on a current account value like a 401k plan. It is based on funding a future income benefit at retirement (age 62 or 65). 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.
  • Typically invested in stocks, bonds, mutual funds and ETFs.
  • 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.
  • Administrative fees are generally more expensive. Investments in the plan fluctuate and must be certified by an actuary each year.
  • $1,250 Setup Fee and $1,500 Annual Fee

Cash Balance Defined Benefit Plan

  • Each participant has a hypothetical individual account with a “cash balance”. The account is easy to understand because it is expressed as a dollar amount similar to a 401k balance.
  • The plan is designed with a fixed annual crediting rate, 3% for example. The business owner is responsible for crediting the account at the pre-determined rate regardless of actual account returns. Investments should be safe, ideally earning a rate similar to the crediting rate and have low volatility.
  • Administrative fees are generally more expensive. Investments in the plan fluctuate and must be certified by an actuary each year.
  • A cash balance plan may be a better option than a traditional defined benefit plan if a business owner’s income has significant yearly fluctuations.
  • $2,000 Setup Fee and $1,500 Annual Fee

What age should a self employed business owner consider setting up a defined benefit plan?

In general age 40 or older. However, if your income is high enough it can be beneficial even if you are in your late twenties. How much can be contributed to a defined benefit plan is determined by your age and your self employed income. For example, someone age 35 would be permitted to contribute less to a defined benefit plan than someone age 50 even if they have the same income.

Here is a case study of a self employed physician age 30 who setup a defined benefit plan. Due to her high income she benefited from setting up a defined benefit plan despite being considered young by defined benefit plan standards.

Some physicians feel they are behind saving for retirement when they are age 30 to 45 compared to their successful peers given their high incomes. Physicians start earning high incomes when they are age 29 to early 30s and may not be financially able to max out their 401k plan until then. As a result, self employed physicians frequently setup defined benefit plans to quickly accumulate retirement savings and catch up.

Here is a case study of a defined benefit plan for a physician age 37. He made a lifestyle change and started his own business.

Here is a case study of married self employed physicians with $950,000 of income age 44 and age 45.  They each setup a defined benefit pension plan and the combined annual contribution was $293,748.

How many years do I need to fund a defined benefit plan?

We tell our clients that in order for a defined benefit pension plan to be a good option, the business owner should feel confident about being able to contribute to a plan for 3 years or more. Most clients fund their defined benefit plans for many years.

For example, a defined benefit plan is probably not the correct choice for someone that receives 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 in future years.

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 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.

Can a 401k profit sharing plan be added to a defined benefit plan?

Yes, a 401k profit sharing plan can be potentially be added to a defined benefit plan. This can increase annual tax deductions.

  • 2017 401k contribution limit is $18,000 and $24,000 if you are age 50 or older. The 2018 contribution limit is $18,500 and $24,500 if you are age 50 or older.
  • When paired with a defined benefit plan the profit sharing contribution is limited to 6% of compensation. The 2017 profit sharing limit is $16,200 which is based on the 2017 income limit of $270,000 X 6%. The 2018 profit sharing limit is $16,500 which is based on the 2018 income limit of $275,000 X 6%.

Note: Contributions to a 401k, 403b, or Thrift Savings Plan through another employer count towards the 2017 contribution limit of $18,000 and $24,000 if age 50 or older. The 2018 limits are $18,500 and $24,500 if age 50 or older. This is an aggregate limit between all of these plans. Contributions made into a 457 plan do not count towards the salary deferral limit. Clients who max out their 401k, 403b or TSP through another employer can still add a profit sharing plan to their defined benefit plan.

What is the administrative fee to add a 401k profit sharing plan to the defined benefit plan?

The fees below apply to have the 401k profit sharing plan and defined benefit plan performed by the same administrator.

  • $0 setup and $250 annual fee to add a 401k profit sharing plan to a fully insured defined benefit plan.
  • $300 setup and $500 annual fee to add a 401k profit sharing plan to a traditional defined benefit plan or cash balance plan.

No fee is charged if you have already setup an Individual 401k (also known as a “Solo 401k”) with another firm and you want to keep it where it is and you decide to not change administrators. However, you will be responsible for all administrative responsibilities and making the correct annual contributions for the salary deferral and profit sharing.

Note: When paired with a defined benefit plan the profit sharing contribution is limited to 6% of compensation. With an Individual 401k the profit sharing contribution is 25% of compensation. A business owner is limited to making a profit sharing contribution that is 6% of compensation when also contributing to a defined benefit plan.

Client Case Studies: Defined Benefit Plan

Here are examples of client case studies who benefited from setting up a defined benefit plan.

2018-03-22

Beacon Capital Management Advisors provides defined benefit plans to the self employed, entrepreneurs, independent contractors and small business owners and is registered in all 50 States. Contact us if you have questions and need advice or if you would like to receive a defined benefit plan proposal.