Defined Benefit Plans
What is a Defined Benefit Plan?
Defined benefit plans are retirement plans that can offer substantial tax deductible retirement contributions and significant future retirement income to the self employed and small business owners. For those that qualify, a defined benefit plan may allow significantly larger contributions compared to an Individual 401k or SEP IRA.
Compared to an Individual 401k or SEP IRA, a defined benefit plan is more expensive administratively, but for the business owner who has a goal of maximizing their retirement contributions and is looking for a way to quickly increase their accumulated retirement assets, a defined benefit pension plan can be an ideal retirement plan solution. Within IRS limits, contributions into a defined benefit pension plan are 100% tax deductible.
How does a Defined Benefit Plan work?
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. Contributions are made according to an actuarial formula to meet the target retirement income benefit. In 2015, the annual benefit payable at retirement can be as high as $210,000 per year. As a result, annual contributions into a defined benefit plan can be even larger than $210,000 in some cases in order to meet that level of retirement income target. There are a number of factors involved with this calculation.
How are the contributions into a Defined Benefit Plan determined?
Calculating the annual dollar amount that can be contributed requires a mathematical calculation performed by an actuary involving the following factors:
- Client's age - In general, the older the client then the larger the annual contribution that can be made into the plan.
- Client's income - The calculation is based on the average of the client's highest 3 years of income. The greater the income then the greater the annual contribution can be (up to certain limits). Depending on a client's income, the annual benefit payable at retirement can be as high as $210,000 per year in 2015.
- Planned retirement age - In general, at least 5 years from the year the plan is adopted.
- Investment performance - In the years after the defined benefit plan has been established an annual actuarial calculation is made based on the performance of the investments in the plan. The actual performance of the portfolio can impact the annual contribution amount that will need to be made so therefore having a portfolio that minimizes volatility is often prudent. When a defined benefit plan is established there is an rate of return assumption that is factored into the actuarial calculation to determine the annual contribution amount that is necessary in order to fund the future retirement income benefit. Each year the actual return of the portfolio will be compared to the rate of return assumption. When the portfolio's actual return is greater than rate of return assumption then there will be a smaller required annual contribution. Conversely, when the actual return is less than the rate of return assumption then the annual contribution will need to be increased to make up the shortfall. On an annual basis, an actuary makes calculations to determine the amount needed to be contributed into the plan to ensure the future target retirement income goal is reached.
Who is a good candidate for a Defined Benefit Plan?
Defined benefit plans are ideal for clients with high earned income and are either self-employed or small business owners with 4 or less full time employees.
- Age 45 or older
- Clients who would like to maximize their retirement contributions in excess of the limits of the Individual 401k or SEP IRA.
- Clients with stable and predictable income (because of the large tax deductible funding commitment). You are obligated to make annual contributions once your plan is established. Funding a defined benefit plan involves a commitment to invest significant amounts each year for the life of the plan. Within certain IRS limits, clients can decide how much of their current income they can comfortably afford to contribute to the plan, but once this annual contribution amount is established then funding a defined benefit plan is fairly rigid and must be made annually.
Defined benefit plans may be beneficial to older employees who may feel they are behind with their accumulated savings for retirement and need (or want) to make significant contributions to accumulate assets rapidly over a relatively short period of time.
Another scenario when a defined benefit plan may be a good choice is for a dual income household, with one spouse that is self employed, and is in the fortunate position of being able to live off of one income. As a result, they may be able to afford to make a retirement contribution using a significant portion the self employed spouse's income into a defined benefit plan.
Another scenario when a defined benefit plan may be a good choice is for someone that is working full time with one employer and then has a separate self employed one person consulting business. This individual may be able to contribute a significant portion of their self employed income into a defined benefit plan.
A partial listing of some of the occupations that might qualify
- Financial Planners
- Graphic Designer
- Independent Corporate Director
- Independent Insurance Agent
- Manufacturer's Rep
- Mortgage Broker
- Real Estate Agent
- Software Developer