The old-fashioned defined benefit plan may be vanishing from big companies, but it has found a new home among sole proprietors.
There’s no faster way for a successful middle-aged business owner to build a big retirement account. And as a bonus, the owner’s defined benefit contributions can dramatically cut their annual income taxes.
Chances are that these significant attractions will come as news to your clients. Few business owners are aware of all their retirement plan options.
Defined benefit plans are designed to produce a specific annual retirement income based on the plan participant’s salary. Your maximum tax-deductible annual contribution is the amount needed to accumulate $2 million by the time you’re 65 years old. In other words, the older you are and the more you earn, the bigger that contribution will be.
Your annual contribution is determined by an actuarial calculation that factors in your age, salary, retirement date and various assumptions about life expectancy and annual investment returns.
A 55-year-old client with $250,000 of net annual self-employment income, who plans to retire at 65, could save $116,000 a year in a defined benefit plan and salt away an additional $34,300 in 401(k) and profit-sharing plans, said Alan T. Nahoum, a White Plains, N.Y.-based actuarial consultant.
“It can add up to huge dollars,” he added. “Sometimes we work backwards to determine a client’s DB contribution, based on how much he needs to live on.”
The actuarial calculation must be repeated every year to make sure the plan is on track. You don’t want the plan’s annual investment returns to exceed the actuarial assumption, noted Mr. Nahoum, because if plan assets build too rapidly, you’ll have to reduce or eliminate your contributions to avoid being over-funded.
“An over-funded plan is subject to a 50% excise tax and personal income taxes on top of that,” he explained. “You can lose 85% of the excess to taxes.”
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So what are the drawbacks of a defined benefit plan?
The plan must cover all eligible employees. Generally speaking, that means anyone who is at least 21 years old and has worked for the company for a year or more. How much that will cost depends on company demographics. For example, it takes much bigger annual contributions to fund a retirement benefit for a highly paid 55-year-old employee than for a low-paid 25-year-old. The plan also must cover two employees or 40% of the employees, whichever is greater, noted Mr. Nahoum. “If a husband and wife work in the business, the plan must cover them both.”
Annual defined benefit contributions are mandatory. These plans work best for clients who have a profitable business with predictable cash flow.
A defined benefit plan’s administrative expenses are greater than those of small company and one-person 401(k) plans. Mr. Nahoum estimated that a one-person defined benefit plan costs $3,000 to $4,000 to set up and $1,500 to $2,500 a year to maintain.
To encourage retirement saving, the government picks up part of this cost for new plans. For the first three years, the defined benefit plan’s owner gets a $500 annual tax credit for its administrative expenses.
The ideal client for a defined benefit plan is a sole proprietor or small business owner who’s 10 years or less away from retirement, eager to cut income taxes and anxious to make up a shortfall in their retirement savings.
The client’s defined benefit contributions move assets from their business, where they’re vulnerable to taxes and creditors, to an account that’s sheltered from both. And when the client retires, they don’t have to convert the fully funded $2 million plan into annuitized yearly income if they don’t want to. If the client prefers, they can keep adding to the account by rolling it into an individual retirement account.
