Benefits of a defined benefit plan

Defined Benefit plans can prove to be the best pension plan if you are a self employed individual or small business owner with a lot of free cash flow and over the age of 50. It can also significantly reduce your income tax liability each year and increase your retirement savings manifold. Small business owners are also required to provide some benefits to the employees in a defined contribution plan and it could be a great retaining factor for some of the best employees that you would want to retain.

Let’s explore some of these benefits in detail:

Contribution Amounts: You can contribute $24,000 to a 401(k) and $54,000 to a profit sharing plan if you are above 50. However, the contribution amount to a defined benefit plan is significantly higher and is calculated by an actuary each year. This amount is based on your age, compensation history and the years of service. You can use our online defined benefit calculator to estimate your contribution amount.

Tax Deductions: Contributions to a defined benefit plan are considered a business expense and you can avail a deduction on it. This typically means lowering your taxable income significantly each year.

Case Study: Retirement Plan for self employed individual

Client 1

Employment status: Self employed

Three year average income: 100,000 as W-2 compensation/Schedule C income/K-1 Income

Participant’s age: 50

A participant with the above mentioned parameters can accumulate $ 1,248,535.08 till s/he reaches an assumed retirement age of 62. In the first year, a maximum contribution of $ 82,788.00 can be made to the defined benefit plan.

Client 2

Employment status: Self employed

Three year average income: More than $265,000 as W-2 compensation/Schedule C income/K-1 Income

Participant’s age: 50

A participant with the above mentioned parameters can accumulate $ 2,621,923.68 till s/he reaches an assumed retirement age of 62. In the first year, a maximum contribution of $ 166,267.00 can be made to the plan.

Case Study: Defined Benefit Plan for a business with employees

The IRS mandates that a business owner benefiting in a defined benefit plan should make some contributions for the employees also. However, the IRS provides significant leeway in how the contributions are provided to the employees.
One of the pension plan design that proves to be the most efficient for the business owner is the floor offset defined benefit plan. In this design, the business owner benefits in the defined benefit plan and the contributions to the employees are provided in a profit sharing plan. Please read more about a floor offset plan here.
If you have a small business with a few employees, below is how the pension plan contributions would look for your business:

floor-offset-plan

Case Study: Can a person who has a full time job and is also self-employed open a defined benefit plan?

The short answer is yes, but let’s delve deeper into this situation. Let’s assume you have a full time job and the employer provides a profit sharing and 401(k) plan but no defined benefit plan. You also have a consulting practice that generates $100,000 – $150,000 in revenue each year. The tax bill on the consulting practice is a significant amount each year!

A person in this situation can open a defined benefit plan for the consulting practice. If s/he is above the age of 50, they can contribute the amount mentioned above. This could significantly reduce the income tax liability each year.

To know more about how to set up a defined benefit plan please read here.