Defined Benefit Plan
What is Defined Benefit Plan?
In the realm of retirement planning, defined benefit plans stand out for their promise of guaranteed income. This guide explores every facet of defined benefit plans, ensuring that you are well-equipped to understand and maximize their potential.
A Defined Benefit Plan is a type of employer-sponsored retirement plan where employee benefits are calculated based on a formula, considering factors such as salary history and duration of employment. These plans guarantee a specific retirement benefit amount, often based on the employee’s final salary and years of service.
A Defined Benefit Plan is a type of employer-sponsored retirement plan where employee benefits are calculated based on a formula, considering factors such as salary history and duration of employment. These plans guarantee a specific retirement benefit amount, often based on the employee’s final salary and years of service.
Business owners or self-employed individuals should sponsor a Defined Benefit Plan to contribute significant amounts to their pension while lowering taxable income.
As a business owner or a self-employed individual, you take all the risks associated with the business and then forfeit a large part of your income to the government in the form of taxes! Wouldn’t you want to put a large part of your pre-tax money into a Pension plan and claim a tax deduction? Of course, you know all about 401(k) and profit-sharing schemes, but let us introduce the monster into the world of retirement schemes. They are Defined Benefit Pension Plans!
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How does Defined Benefit Plan Calculator work?
As per IRS rules, an individual can make 100% of their compensation in retirement. For example, if a self-employed individual has a business that is registered as an S-Corp. The compensation from the business is a W-2 income of $100,000 and the remaining portion is K-1 income for the business owner.
If we were to apply the IRS rule to this individual, he can earn $100,000 each year from his own defined benefit plan after retiring at an assumed retirement age of 62. The IRS then requires the defined benefit plan to estimate the lifespan of this individual. There are IRS prescribed mortality tables that are supposed to be used. For example, the mortality table that is used in this case estimates that this participant will live until he is 82. Without any interest rate plays, when the person retires at age 62, he will need $2 million in his account to be able to withdraw $100,000 each year.
The mortality estimates may not play out accurately for a single individual, but this is the concept of the defined benefit plan. This individual will now have to fund for the $2 million pot which is called the lump sum at retirement.
If this individual is 52, he has 10 years to fund the $2 million, which basically means he needs to contribute $200,000 each year.
This is exactly how a Defined benefit plan calculator works, albeit with a lot of interest rate assumptions. There cannot be a better example of a defined benefit plan than this.
If we were to apply the IRS rule to this individual, he can earn $100,000 each year from his own defined benefit plan after retiring at an assumed retirement age of 62. The IRS then requires the defined benefit plan to estimate the lifespan of this individual. There are IRS prescribed mortality tables that are supposed to be used. For example, the mortality table that is used in this case estimates that this participant will live until he is 82. Without any interest rate plays, when the person retires at age 62, he will need $2 million in his account to be able to withdraw $100,000 each year.
The mortality estimates may not play out accurately for a single individual, but this is the concept of the defined benefit plan. This individual will now have to fund for the $2 million pot which is called the lump sum at retirement.
If this individual is 52, he has 10 years to fund the $2 million, which basically means he needs to contribute $200,000 each year.
This is exactly how a Defined benefit plan calculator works, albeit with a lot of interest rate assumptions. There cannot be a better example of a defined benefit plan than this.
Point to note when using our DB Plan Calculator:
Please note the contribution amount generated by our defined benefit plan calculator is only an estimate. You still need an actuary to calculate the contribution amount for your existing defined benefit plan. The defined benefit plan calculated amount is an estimate only for setting up the plan in the first year. Please do not contribute to an already existing plan using our defined benefit calculator. Feel free to reach out to us at info@pensiondeductions.com if you need any assistance with setting up a defined benefit plan.
Who can set up a Defined Benefit Plan?
Every small or large company can set up a defined benefit pension plan. Even a self-employed individual can set it up as long as there is significant money to contribute to the plan.
Typical examples of businesses that set up a defined benefit plan are:
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Self-Employed Individual Consultants
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Individuals with Small Business and a Full-Time Job
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A Medical Practician with few Full-Time Employees
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Real Estate Agents with their Own Agency
Advantages of a Defined Benefit Pension Plan
- Substantial advantages (read money) can be provided and accrued during a short period of time – even with early retirement.
- Employers can contribute (and deduct) more than other pension plans like defined contribution plans.
- The plan offers a predictable and guaranteed benefit, and the benefits do not depend on the return on assets.
- This plan can be used to promote some business strategies through subsidized early retirement benefits.
- The Defined Benefit Plan favors older participants as they are nearer to retirement and need to accrue benefits at a faster rate than younger participants.
Calculate Business owners/self-employed individuals’ contribution towards DB Plan:
Use our defined benefit calculator to estimate how much of the deduction you can take each year and how much of the pre-tax money you can accumulate in the plan. (pssst…. For a middle-aged individual in the upper tax bracket, the deductions are generally in the range of $200,000 a year, so it might be worth a minute.
Rules of Defined Benefit Plan
Eligibility criteria to start a Defined Benefit Plan
A defined benefit pension plan is an employer-sponsored pension plan, so this is typically set up by a business. All types of businesses can set it up, however, a prudent decision needs to be made based on the goals and the profitability of the business. Even self-employed individuals and sole-proprietors can start a defined benefit plan as long as the cost justifies the benefits earned.
How are contributions determined in a Defined Benefit Plan?
The defined benefit pension plan is always funding for a specific benefit amount at a specific date subject to IRS maximums. This amount is discounted to the current date using the IRS specified interest rate. Since it is not possible for a business to contribute the exact same amount each year, a range is created and a contribution can be made within the range. This range is defined by the minimum and maximum amounts that can be contributed to the plan.
If the plan sponsor always funds closer to the minimum, the minimum will keep increasing to catch up with the increasing liability of the plan.
The maximum contribution will keep reducing if the plan sponsor keeps funding closer to the maximum amount each year.
Contributions to the defined benefit plan should be deposited within 9.5 months of the end of the plan year.
Minimum required contribution in a Defined Benefit Plan
The minimum required contribution for a defined benefit pension plan is the amount that the plan sponsor (usually the employer) is required to contribute to the plan in order to ensure that there are sufficient assets to pay the promised retirement benefits to plan participants.
The minimum required contribution for a defined benefit plan is determined by several factors, including the plan’s funding status, the age and compensation of plan participants, and the plan’s benefit formula. The minimum required contribution is typically calculated annually by an administrator (like us!) who takes into account these factors and determines the amount that must be contributed to the plan to meet its funding obligations.
The minimum required contribution is an important consideration for employers who sponsor defined benefit plans, as failure to make the required contributions can result in penalties, interest, and other fees. In addition, underfunding of a defined benefit plan can put participants’ retirement benefits at risk, which can have legal and financial consequences for the plan sponsor.
It’s worth noting that in some cases, employers may choose to contribute more than the minimum required contribution in order to fund the plan more aggressively and reduce the risk of underfunding. Employers may also choose to make additional contributions to the plan in order to improve the plan’s benefits, such as by increasing the retirement benefit formula or offering early retirement options to participants.
The minimum required contribution can be reduced with timely amendments to the plan.
Maximum Deductible contribution in a Defined Benefit Plan
We just said that an employer could contribute more in a highly profitable year to the defined benefit pension plan. However, this is also subject to IRS limits. These calculations and amounts are covered under IRS Section 415 and are always calculated by an actuary.
Broadly speaking, the maximum contribution would be equal to unfunded liability of the defined benefit plan (liability – assets) + a multiple of the benefit increase in the year.
No one is permitted to contribute amounts higher than the maximum deductible contribution as it would lead to a severely over funded defined benefit plan.
Defined Benefit Plan Example
Defined Benefit Plan VS 401k Plan
Defined Benefit Plan
VS
401k Plan
| Feature | Defined Benefit Plan | 401k Plan |
|---|---|---|
|
Contribution |
Employer Funded |
Employee Funded, often with employer match |
|
Benefit Calculation |
Predetermined Formula |
Based on Contributions and Investment Returns |
|
Investment Risk |
Employee Bears Risk |
Employee Bears Risk |
|
Payout |
Fixed Monthly Payments |
Lump Sum Or Periodic Withdrawals |
|
Portability |
Not Portable |
Portable |
|
Vesting |
Often Requires Several Years |
Immediate For Employee Contributions, Schedule For Employer Contributions |
|
Tax Treatment |
Taxed Upon Receipt |
Taxed Upon Withdrawal (Except Roth 401(K)) |
|
Regulation |
Heavily Regulated |
Regulated With More Investment Flexibility |
|
Plan Complexity |
More Complex And Costly To Administer |
Simpler And Less Costly To Administer |
|
Control |
Employer Control |
Employee Control Over Investments |
Guide to Set Up a Defined Benefit Pension Plan
Contact an actuary or a pension consulting firm (like us!)
At first, a calculation needs to be performed about how much you can actually contribute to a defined benefit pension plan. Unlike 401(k) and profit-sharing plans, contributions to a defined benefit plan vary from person to person. You can calculate an estimate using our online defined benefit calculator. Feel free to email us at info@pensiondeductions.com for quick assistance.
Talk to your CPA
Once you have an initial estimate from the contributions, you will need to collaborate with your CPA to ensure that you have sufficient cash flow to contribute to the defined benefit plan.
Draft the Plan Document
Once the amount has been decided between you and your CPA, the actuary will need to draft the plan document for you. You will need to provide the legal name of the company, the EIN, address, and other details.
Set up the defined benefit plan investment accounts
After the plan document has been drafted, you are all set to open the investment account for the plan. You should reach out to your financial advisor or a broker to set up the accounts. Make sure you tell them to open a ‘qualified account’ so that the investment gains are not taxed at the source.
File with the IRS
All qualified plans are required to file annual returns with the IRS. Note that these returns are different from the company tax returns and your personal tax returns. Also, note that the CPA or financial advisor cannot file these returns since these are required to be certified by an actuary. We specialize in this area and can provide you with valuable advice and services that could end up saving thousands of dollars and getting a boost to your retirement planning. You can also email us at info@pensiondeductions.com.
Contribution limits to a defined benefit plan?
There is a common misconception that the contribution to a defined benefit plan is limited to $220,000. However, this is not true. The contribution amount to a defined benefit plan is calculated by an actuary and varies based on the age, income, and years of service of the individual.
Can you buy life insurance in a defined benefit plan?
What is the benefit of buying a life insurance policy inside a defined benefit plan, you may ask? The primary benefit is that the premiums for the policy are paid from the contributions made to the defined benefit plan. The contributions are tax-deductible and this effectively makes the premiums tax-deductible too! However, the face amount of the life insurance and the premium amounts are subject to maximums calculated by the actuary. The entire contribution of the DB plan cannot be used to pay the insurance premiums. As such, a portion of the contribution will be used to pay the premium and the remaining amount will be invested as a side fund in non-insurance investments. The insurance policy in the plan is typically a whole life policy or universal life policy. The face value of the policy will remain the same irrespective of the type of policy. If you are an insurance agent, feel free to reach out to us to know more about these technical details: info@pensiondeductions.com
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Calculate Now!Compensation for a Defined Benefit Pension Plan
As it would be clear by now, a DB Plan is based on the individual participant’s age and compensation. But what is Compensation? Typically, earned income (income subject to self-employment taxes) has to be used as compensation. The IRS has very specific definitions of what income can be considered as compensation for a DB Plan.
- If your business is a partnership, and taxed as a partnership, you can consider your K-1 income for calculating compensation for the purpose of a defined benefit plan. The calculation would broadly be along the following lines: Net K-1 income after all deductions – ½ FICA – DB Plan contributions.
- If your business is a partnership taxed as a corporation, only your W-2 can be used for the purpose of a Defined Benefit Pension Plan.
- If your business is a Corporation and taxed as a Corporation, only your W-2 compensation can be used for the purpose of the defined benefit plan. S-Corp owners would also receive a K-1 from the business, but since the K-1 from a Corporation is not subject to self-employment taxes, it cannot be used as compensation for a DB Plan.
- If your business is taxed as sole-proprietorship, you would file a Schedule C for the business. Your Net Schedule C is used for calculating the compensation for the purpose of the Defined Benefit Pension Plan contribution. This is typically done as follows: Net Schedule C after all deductions – ½ FICA – DB Plan Contribution This is only a basic formula and there are ways in which the correct calculation has to be done. Please feel free to email us if you are a sole-proprietor and want to set up a defined benefit plan: info@pensiondeductions.com
- Compensation for a business that you do not own cannot be used for the purpose of the DB Plan. In this case, if you have a full-time job and a business on the side, you can set up a DB Plan for the business, but you cannot use compensation from your full-time job for the purpose of the defined benefit plan.
FAQ's
Can you set up a defined benefit plan after age 70?
Some retirement plans cannot be set up after a certain age, however, defined benefit plans do not fall into this category. So if you have a significant amount of income after age 70, you can still set up a defined benefit plan and contribute a large amount of money. The IRS typically requires participants to take a taxable distribution from the plan after age 72 (was age 70.5 prior to the Secure Act passed in Dec-2019). However, the defined benefit plan can utilize unique vesting schedule options to suspend the distributions for a few years. This will give you the option to defer taxes in high-income years and roll over the remaining balance to an IRA.
Investments for a DB Plan
Investment ideas for large defined benefit plans are totally different from investment ideas for small defined benefit plans that are typically set up for the benefit of business owners or sole-proprietors.
Think of a defined benefit plan like a bucket. One can fill this bucket either with contributions or with investment appreciation. Most business owners set up defined benefit plans with the goal of getting large tax deductions. If this is the goal, one’s rate of investment return should be as low as possible so that the bucket is not filled up by investment returns.
What happens to the money in the DB Plan?
A trust account is opened in the name of the defined benefit plan. This account could be opened with any institution like Fidelity, Charles Schwab, TD Ameritrade, etc. The contribution money is deposited into the account as and when cash flow is available. The plan sponsor is also the trustee (in most cases) for the investments in the plan. The trustee can decide to invest the money in any exchange-traded product like a stock, bond, mutual fund, ETF, etc.
Does Your Business Need DB Plans?
If you answered YES to ANY of the above questions, you MUST have a Defined Benefit Pension Plan.
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Implementing a DB Plan for a business owner with employees is such a complicated task that it takes a skilled actuary to design the plan and allocation to the employees. And this is where we come into play.
