Despite their reputation, traditional defined benefit (retirement) plans can be a valuable tool for small business succession planning. Defined benefit pension plans are often associated with unions and financial mismanagement, leading to severe underfunding and government bailouts. They are often seen by many within the pension industry itself as a relic. However, the annual contributions that can be made to a defined benefit plan often dwarf the annual contributions that can be made to a 401(k) plan. For this reason, small business owners approaching retirement age often find defined benefit plans an attractive way to save a significant amount for retirement over a five to ten year period. And under the right circumstances, a defined benefit plan can help fund the sale of a small business to a younger generation.
Contribution and deduction limits impact small business owners’ retirement savings
Annual contributions allowed on behalf of a single participant in a 401(k) plan are limited. For 2022, the maximum combined employer and employee contributions are $61,000 per participant (employees age 50 or older can earn an additional $6,500 in optional catch-up deferrals). Over the life of their business, small business owners often reinvest heavily in their business at the expense of retirement savings. Therefore, a 401(k) plan by itself may not be sufficient for a small business owner to save for retirement over a limited number of years.
In a defined benefit plan, however, an actuary determines the minimum required and maximum allowable annual employer contributions. The range of contributions generally depends on the age of the participants, their compensation history and accrued benefits, as well as the value of the assets already held for investment purposes by the plan trust. The annual contributions to a defined benefit plan due to an older, well-paid participant (i.e. a business owner) can reach $300,000 or more. Note that a defined benefit plan may be designed to allow lump sum payments (instead of the typical monthly or annual benefits paid until death). Under current Internal Revenue Service limits, the optimal defined benefit plan participant is eligible for a defined benefit plan lump sum payment greater than $3 million, and the lump sum can generally be transferred to a retirement account. individual (IRA) or other tax plan. -qualified retirement plan where he continues to earn tax-deferred investment returns.
Using a Defined Benefit Plan for Business Succession Planning
A defined benefit plan may be suitable for the sale of a business because it reduces the cost of buying the business for the buyer while providing tax-deferred compensation to the seller. For example, consider a situation where a business owner wishes to sell the shares of his company to a younger key employee (or a group of younger key employees). As is usually the case with such a sale, the business owner will remain an employee for a few years after the transaction to ensure a successful transition. In anticipation of the sale, the seller sets up a defined benefit plan and begins to accumulate rights under the plan a few years before the transaction while maintaining minimal funding. At the point of sale, the selling price of the shares is reduced by the amount of contributions needed to fund the former owner’s retirement benefit. During the post-transaction period (while the former owner is still employed), the company makes contributions to the defined benefit plan to fund the former owner’s accrued benefits. In effect, it allows the buyer to fund a portion of the stock sale with tax-deductible pension plan contributions and provides the seller with a tax-deferred benefit. As a bonus, the defined benefit plan is designed to allow for lump sum payments. Upon retirement, the seller receives a lump sum distribution that rolls over to a traditional IRA (an event that does not trigger income tax) where they continue to earn tax-deferred investment returns for years or even decades. after the sale of the business. .
It should be noted that there is a compromise here. Proceeds from the sale of the business are normally subject to capital gains tax, but distributions from a tax retirement plan or IRA are generally subject to income tax (and the income is generally taxed at higher rates than capital gains). It is important for a business seller to consult with a CPA (a certified public accountant) or trusted financial advisor to determine if using a defined benefit plan is likely to result in a better outcome for the seller.