Insights & News

June 2015
Business Owners

Advantages of Defined Benefit Plans for Small Business Owners



If you are a sole proprietor or small business owner with only a few employees, you may be missing out on a great opportunity to achieve two important goals:  mitigating your income tax liability and increasing your retirement savings.  Most business owners have already established a retirement savings plan for their company.   Typically, this is done through a defined contribution plan, such as a 401(k) plan or SEP-IRA.  However, many do not realize they can also establish a defined benefit plan, commonly referred to as a pension plan.  Defined benefit plans can be a very effective tool to save a substantial amount of money and significantly lower an owner’s individual income tax liability.  


In 2015, the maximum contribution allowed per participant for a defined contribution plan, including employee elective deferrals and employer contributions is $53,000 if you are under the age of 50. The maximum contribution is $59,000 if you are 50 or older.  This amount may not be sufficient to fund the retirement nest egg you need to achieve all your retirement goals. Under the right circumstances, a defined benefit plan can be crafted to allow you to make significantly higher contributions for yourself than your employees, increasing your ability to save, while minimizing the expense of contributions for your employees.  


Defined benefit plans also have maximum contributions but they are calculated differently which can work to your advantage.  An actuary will calculate the annual contribution amount necessary to provide a pre-determined retirement benefit.  In 2015, the maximum annual benefit that can be paid under a defined benefit plan is $210,000.  The maximum compensation that can be used to calculate this benefit is $265,000.  If you are 5-10 years away from retirement, you may be eligible to make annual contributions in excess of $100,000.  If you find yourself nearing retirement but haven’t been able to save sufficiently due to the demands of either a growing business or family commitments, such as college funding, this can be an effective strategy for saving a substantial amount of money in a relatively short period of time.  


Another major advantage of a defined benefit plan is that the contributions are considered business expenses which will lower your net business income and the amount of income that is taxable.  Many business owners may find they can pay for a large portion of the annual contribution through the reduction in their income tax liability.


Defined benefit plans can typically be opened at most major brokerage firms, such as Charles Schwab, Fidelity, and TD Ameritrade.  This approach allows you to work with your current financial advisor to invest the funds with the same risk profile and asset allocation as your other assets.  In addition, upon retirement, you do not need to annuitize the account into a lifetime income stream.  Instead you can roll over the defined plan account into an IRA account, allowing you to consolidate your retirement assets and continue to invest according to your risk tolerance and retirement goals.  


Defined benefit plans are not without their risks and costs.  You will incur additional costs for administering and maintaining the plan.  You are required to make the contributions each year regardless of your income for that year and you are required to make contributions on behalf of all eligible employees.  There are also certain limits that apply when you have both a defined contribution and defined benefit plan.  For example, the employer contribution made to the defined contribution plan is limited to 6% of the net business income.  However, you may find that the larger contributions, increased savings, and income tax reduction may offset the risks, additional costs, and limitations.  


I recently worked with a client who is employed full-time and has a consulting business on the side.  He is deferring the maximum amount allowed to his employer-sponsored defined contribution plan.  His consulting business provides a steady income and he has an agreement in place that provides a high level of assurance that the income will remain steady for the next 5-10 years.  In 2013, a large percentage of his earnings from the consulting practice were used to pay income taxes.  We worked with a third party administrator to open a defined benefit plan for his consulting practice.  In 2014, he was able to contribute $155,000 to the plan.  This contribution significantly reduced his 2014 income tax liability, saving him ~$70,000.  Using this strategy he was able to effectively redeploy his consulting income from income tax payments to a saving strategy that will provide greater security in meeting his retirement needs.


There are many retirement options available, both defined benefit and defined contribution.  As a business owner you are in the position to determine the plans that best meet all your goals, such as mitigating your current taxes, providing more wealth for retirement, providing incentives for your employees to save towards a secure retirement, or rewarding employees who have contributed to the success of your company.  A defined benefit plan can enable you to accelerate your savings.  Before entering into any new plan, you need to work with your advisors, such as your wealth manager, tax accountant, and third party administrator, to complete a suitability study to determine which plans best meets the needs of you, your employees, and your business.

This article originally from The Business Monthly.


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