Defined Benefit Plan for Self Employed: Tax Deductions are a much chased around topic all year round, and why should it not be! As a self employed individual you work hard taking all the business risk only to realize that a large share of your income will have be given away to the government in the form of taxes. Of course, there are several small tax deductions that you can take and bring down the amount of taxable income. However, this list of tax deductions is long and each individual item is worth only a few hundred dollars. This is where a defined benefit plan comes in which can allow you to deduct several thousand dollars off your income, and is one of the most favored retirement vehicle of the high income earner.

Unfortunately, the intelligentsia tend to concentrate around a 401(k) plan, SEP IRA or a profit sharing plan and a defined benefit plan finds no mention. However, a defined benefit plan is capable of generating a tax deduction of up to $200,000 and higher in some scenarios, making it an ideal choice for a self employed individual looking for a large tax deduction. One of the reasons why defined benefit plans find no mention is the complexity of the plan and that it requires the certification of an enrolled actuary. This is where we come in,to mask the complexity for you, provide services for drafting the plan document, actuary certification, and annual administration including IRS filings. In the article below we will demonstrate how a defined benefit plan is simple, capable of providing a large tax deduction and how you can get one for yourself. Use our Defined Benefit Calculator to estimate how much you can accumulate in a Defined Benefit Plan and generate tax deductions each year.

What is a defined benefit plan?

Let’s be technical for a moment. A defined benefit plan promises a certain monthly benefit to the plan participants after retirement. An actuarial valuation needs to be performed to estimate mortality rates of participants and the amount of money required to fund their retirements.

If you are a self employed individual, this is where the traditional definition ends, and the magic begins!

Assuming a scenario with no employees, you are the owner of the company sponsoring the plan and the only participant as well. (If you have employees you might want to read about a floor offset defined benefit plan). This effectively means you are having your company contribute for you, which makes the defined benefit plan very similar to a profit sharing plan. The major difference is that the IRS limits contributions to a profit sharing plan each year. However, the limitations on a defined benefit plan are determined by the plan design and are typically much higher.

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Self Employed Tax Deductions

A self employed individual who has had a net income of over $200,000 in the past can contribute between $100,000 and $250,000 each year and claim a tax deduction for this amount. (If you have employees and are looking to contribute a smaller amount you might want to read about new comparability profit sharing plan here)

Instead of limiting the annual contributions, the IRS limits the total amount of money that one can accumulate in the defined benefit plan at retirement. This amount is determined on the participant’s past compensation history, age, and the plan formula. The plan formula is arrived at after a consultation between the actuary and the client so that the plan provides enough flexibility regarding contribution amounts.

Another thing the IRS limits is that the annual benefit after retirement cannot be more than $215,000 or 100% of you past income. When we design the plan for you, we take all these limitations into consideration and tell you a minimum required contribution and the maximum permitted contribution. In any given year, the minimum required contribution can be reduced if your business experiences lesser cash flow.

Are the contributions to a defined benefit plan deductible?

Yes, if you have only one plan, then the entire contribution can be deductible. There are of course, contribution and deductible limits, but those change each year and can only be calculated by your actuary.

How much can a self employed individual contribute to a defined benefit plan?

You can use our defined benefit calculator to estimate the amount of contributions in the first year.

Is there a deadline to contribute to a defined benefit plan?  

Yes, contribution to a defined benefit plan can be made through out the financial year. But all contributions have to be made before the tax returns for the company are filed or until 9.5 months after the close of the plan year, whichever is earlier.

Can you not contribute to a defined benefit plan in a particular year?

Yes! A contribution can be skipped in a particular year if are having a tough year in your business. Defined benefit plan typically have a minimum required funding, however, the amount depends on how well funded the plan has been in the past.

You will need to work with your actuary in order to freeze the accruals for that particular year. It is advisable to talk to your actuary about the funding needs for the defined benefit plan early in the year.

Can a self employed individual contribute to more than one pension plan?

Typically a defined benefit plan will create an opportunity for a large contribution. However, you can still contribute to other plans if you want to. Contributing to multiple plans would require maintaining and paying fees for multiple plans, so you might only want to do this when the total cash flow is more than what can be contributed to one plan.
If you have a defined benefit plan, you can contribute a maximum of $18,000 to a 401(k) plan and an additional amount of $6,000 if you are above the age of 50. Contribution to a profit sharing plan or a SEP IRA will be limited to only 6% of your W-2 income if you already have a defined benefit plan.

If you are convinced that a defined benefit plan can be one of your preferred self employed tax deductions, feel free to reach out to us and learn how we can quickly install a plan for you. Schedule a conference call with us.