For the good business owner, a defined benefit plan can be the path to a very comfortable retirement. The problem is that far too few business owners are aware of the tax and retirement benefits associated with a defined benefit plan. According to CNN Money, the number of companies with defined benefit plans is only 4%, up from 60% in the 1980s.
In general, any business can adopt a Qualified Pension Plan (QPP). The business can take any legal form, such as a sole proprietorship, LLC, or corporation. The most popular type of QRP is the defined contribution plan. A defined contribution plan is an employer-sponsored pension plan that allows contributions to be made for an employee based on a percentage of the employee’s earnings up to a maximum annual amount. Defined contribution plans do not guarantee a specific retirement benefit.
The 401 (k) plan is the most popular type of defined contribution plan. A 401 (k) plan, also known as a cash or deferred arrangement (CODA), is essentially a type of profit-sharing plan that allows all eligible employees to carry a portion of their compensation back into the plan. . A 401 (k) plan allows for employee deferrals and may also allow employer profit sharing contributions.
Employees can contribute up to $ 19,000 to their 401 (k) in 2019; there is a limit of $ 56,000 on the combined employer and employee contributions. If you are at least 50 years old, those numbers increase by $ 6,000.
Unlike a QRP, which does not have a specified retirement benefit, a defined benefit plan provides a predetermined benefit. A cash balance plan has become the most popular type of defined benefit plan. Once the retirement benefit goal is established, the employer’s contribution required to meet the benefit goal is actuarially determined on an annual basis. The main advantage of setting up a defined benefit plan is the high annual contribution limits, which are based on many factors, including age and income. According to the IRS, with a defined benefit plan, a member’s annual benefit generally cannot exceed the lesser of the following amounts:
• 100% of the average salary for their three highest consecutive calendar years (reduced for less than 10 years of service), or
• $ 225,000 for this year. Dollar amounts are subject to cost of living adjustments in future years (reduced for less than 10 years of membership).
Having the ability to deduct nearly four times the amount of a 401 (k) plan is reason enough to wonder if a defined benefit plan may be a good choice for you and your business.
Since the employer is the party responsible for adopting a QRP, the following factors are usually taken into account before an employer decides which type of pension plan to adopt:
• Individual financial situation: The employer should take into account the financial situation of the business and its owners in order to best determine the type of plan that will provide the most tax benefits. For example, a small business with large profits with business owners who receive generous compensation would be wise to consider a defined benefit plan. On the flip side, a sole proprietorship that has fewer profits and more fluctuations in annual income would likely be better served with a 401 (k) solo plan.
• Age of owners: A young owner with a start-up business may consider a 401 (k) solo plan or a defined contribution plan due to the relatively low costs and the lack of predetermined and forced retirement benefit requirements. However, an employer of a small business with fewer than 15 employees and between the ages of 45 and 65 would enjoy significant tax benefits with a defined benefit plan.
• Age of employees: The age of the company’s workforce can affect the type of retirement plan the company may seek to adopt. For example, an employer whose workforce is predominantly older employees would likely not want to adopt a defined benefit plan because of the potentially high costs associated with funding required employee benefits. A 401 (k) or incentive plan would likely be less costly and still provide its employees with significant retirement benefits.
How does a defined benefit plan work?
Because a defined benefit plan requires the work of an actuary to determine the amount of plan contributions required to fund retirement benefits, it is more complex and expensive than a 401 (k) or pension plan. profit-sharing. In general, the benefits of defined benefit plans are funded over the working life of the participating employee, with tax-deductible annual contributions from the employer.
The employee makes no contribution to the plan. Instead, the employer makes all contributions as stated in the pension plan document. In general, employees have no control over investment decisions under the defined benefit plan.
One of the unique features of a defined benefit plan is that the employer must continue to fund the plan, even if the adopting employer has insufficient cash flow or earnings. In other words, the employer is responsible for ensuring that the company can meet the defined benefit amount each year for all participants. If the company does not meet its obligations, the federal government can intervene through the Pension Benefit Guarantee Corporation.
In the right situation, there are huge tax and retirement benefits for establishing a defined benefit plan over a 401 (k) plan. This is especially true for someone who is self-employed in a lucrative field, such as a doctor with a successful practice.
The defined benefit plan is one of the best kept secrets in the retirement world. Unfortunately, secrecy has cost many business owners the opportunity to maximize their tax and retirement benefits. Even with the annual administration fee, which can run up to a few thousand dollars, the tax and retirement benefits associated with a defined benefit plan make it a great option in the right situation.
The information provided here is not investment, tax or financial advice. You should consult a licensed professional for advice regarding your specific situation.