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 on the right 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.

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How to set up a defined benefit plan for self employed?

Setting up a defined benefit plan requires a certain amount of ground work that needs to be put in before you can actually start contributing to the plan.

At first a calculation needs to be performed about how much you can actually contribute to a defined benefit plan. Unlike 401(k) and profit sharing plans, contributions to a defined benefit plan vary from person to person. They are typically based on the age of the individual and the compensation history. You can calculate an estimate using our online defined benefit calculator on this page. A final calculation needs to be performed by an actuary though.

Once you have a final 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. Once the amount has been decided between you and your CPA, the actuary will need to draft the plan document for you.

For examples, your actuary may calculate that you can contribute $200,000 in the defined benefit plan in the first year. However, you might want a lower contribution amount and your actuary needs to be informed of that. Once you, the actuary and your CPA agree on a contribution amount, you are all set to go ahead with the next steps.

Every defined benefit plan requires a plan document which will list all assumptions of the pension plan and ensure compliance with all IRS rules and regulations. This document has to be drafted by an actuary before you can set up the investment accounts for the plan. A new TIN also needs to be registered for the pension plan as it is a distinct legal entity. The actuary will customize a plan document based on the contributions you need. Make sure your actuary provides you a plan document that is pre-approved by the IRS so you don’t need to go through the hassle yourself. You can read more about a pension plan document here.

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 source.

You can start making contributions to the plan as and when free cash flow is available once the investment accounts are open. For the first year, the contribution will be what was decided between you and the actuary. The actuary will calculate a range for each subsequent year along with a recommended contribution amount. You are required to contribute within the range to avoid over funding or under funding the plan. The deposits can be made until you file the tax returns for your business.

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.

The actuary will fill up a form called the Form 5500SF and certify another form called the Schedule SB. You will need to sign the form as the plan sponsor and the actuary will file it electronically. The penalties for not filing these forms run in to hundreds of dollars and the pension plan could end up getting disqualified.

If you are a self employed individual and interested in exploring the idea of a defined benefit plan for yourself feel free to give us a call. 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.

A brief overview of retirement plan options

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 deductions that you can take and bring down the amount of taxable income. This list of deductions is long and each individual item can be worth only a few hundred dollars. This is where retirement plans come in and allow you to deduct several thousand dollars on your income taxes.

There are several retirement plans for self employed individuals out there, but each one is more complicated than the other. Selecting the best plan for yourself and your firm is no easy task and it often leads to frustration.

To make the task easier, we narrow it down to just two variables that are crucial in the decision making process. These are:

  1. Employees: Does your business have employees (Yes/No)?
  2. Free Cash Flow: How much money are you looking to put aside in a retirement plan for yourself?

For a self-employed individual the following retirement plans could prove beneficial:

  • Low Cash Flow: In this situation you can opt for the solo/individual 401(k) plan. People below 50 can make contributions of up to $18,000 and those above the age of 50 can make additional $6,000 contribution adding to a total of $24,000. These limits are adjusted annually by the IRS based on the cost of living increases.

 

  • Medium Cash Flow: Regardless of the size of the business, profit sharing plan is a good plan for a self employed person or a business with medium cash flow or inconsistent cash flow. It allows clients to contribute up to $54,000 annually or 25% of eligible compensation, whichever is lower. This type of retirement plan also provides flexibility in choosing the amount of contributions in any given year. This plan can be beneficial if the company employs the spouse as well and contributions can be made for the spouse, thereby increasing the total amount of contributions.

 

  • Large Cash Flow: With a high cash flow, a self employed individual can always go for a single life Defined Benefit Plan. These plans depend on the age and the compensation of the individual and can allow contributions from 60,000 to 250,000 in some situations. You can use our defined benefit calculator to estimate the amount of contributions in the first year.

 

Are contributions made to retirement plans tax deductible?

Yes, the contributions to a retirement plan are tax deductible.

What are the contribution limits for retirement plans?

The limits vary each year and by plan type. For a 401(k) plan, the maximum possible contribution is $18,000 if the participant is below the age of 50. An additional $6,000 can be contributed as a catch-up amount if the participant is older than 50.

For a profit sharing plan, the maximum possible contribution is 25% of eligible compensation or $54,000, whichever is lesser. The $54,000 limit is inclusive of any 401(k) contribution that the participant makes. Some people make the mistake of contributing the maximum of $54,000 to the profit sharing plan and then contributing an additional $18,000 to a 401(k) plan. This is clearly incorrect. A participant above the age of 50 can contribute the additional $6,000 to the 401(k) plan and that amount is not included when calculating the maximum contribution of $54,000. Such a person can contribute a total of $60,000.

The annual contribution limits to a DB plan vary based on the design and the funding status. Only the plan actuary can provide you an estimate for this.

Is there a deadline to contribute to a retirement plan?

Retirement plan contributions can be made through out the financial year. Contributions to the 401(k) plan should be done before the end of the year. Contributions to other plans can be made after the end of the year, but before the company files its tax returns. The actual deadline could vary based on the type of the plan and the tax election of your company. You should consult with your CPA to get specific deadlines relevant to you.

Can you not contribute to a retirement plan in a particular year?

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

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

Only a lucky few would land up in this situation where they have enough free cash flow and one retirement plan is not sufficient to absorb it. However, you should also make sure that the first retirement plan that you get allows the maximum possible contribution. If you still have excess money, you can go ahead and start a second retirement plan. Please note things get complicated here and you should consult with an experienced actuary to ensure you are compliant with all IRS limits. 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 are you indeed in such a great situation you should consider the situation below:

Typically a defined benefit plan will create an opportunity for a large contribution. However, you can still contribute to other plans if you have maxed out the contribution to a DB plan. If you have a DB plan, you can contribute a maximum of $18,000 as a salary deferral and an additional amount of $6,000 if you are above the age of 50. Additionally, contribution to a profit sharing plan or a SEP IRA will be limited to only 6% of your W-2 income.

If you are convinced that a retirement plan is an appropriate tax saving instrument for an individual like you, feel free to reach out to us.You can email us at info@pensiondeductions.com and one of our consultants will get in touch with you.

You can read here how to set up a retirement plan for yourself. The process to set up any form of retirement plan would be similar to as mentioned in this article.

What is a pension plan document?

Simply put, a pension plan document is like the Constitution of a country. It outlines all the rules and regulations governing the pension plan. Note that the IRS makes certain things mandatory and the plan document cannot overrule those. For a few other things, the plan document can be a little more liberal within IRS limits.

For example, for the purpose of calculation, a pension plan needs to assume a retirement age. The pension plan document can assume the retirement age to be 62 or 65. Similarly, a profit sharing 401(k) plan can provide for immediate entry into the plan up on hire or can prescribe a one/two year waiting period. However, if a two year wait period is selected, the plan needs to provide 100% vesting upon participation for the profit sharing contributions. The selection of the waiting period is the discretion of the plan sponsor, but the vesting schedule up on selecting a two year waiting period is a rule of the IRS and cannot be over-ruled via the plan document.

There are several small technicalities that need to be taken into consideration while drafting the plan document. As such, it is always better to hire the services of a pension firm to draft the document. A specialist firm can help you design the pension plan and the document to reduce the overall cost of funding the pension plan or maximize the contributions for a specified group.

A pension plan document will consist of the following sub parts:

  • Basic Plan Document
  • Trust Document
  • Summary Plan Description
  • Adoption Agreement

Basic Plan Document: This section will define all keywords related to the pension plan. What is the definition of an eligible employee, or what is the meaning of accrued benefit can be found in this section.

Trust Document: A qualified trust needs to be created to manage the money in the pension plan. Depending on the size of the plan, appointing a third party trustee may be an option. For smaller defined benefit plans with only a single participant, the plan sponsor can himself act as the trustee. For profit sharing plans with participant money, it is advisable to appoint a financial advisor to ensure all processes are followed.

Summary Plan Description: A Summary Plan Description provides a basic description of the plan in lay man terms. A copy of the SPD is generally given to the plan participants for their understanding.

Adoption Agreement: The adoption agreement will look more like a checklist and the provisions for the plan will be checked on the adoption agreement. The adoption agreement itself is of several parts. Each part will seek to address a specific set of rules:

  • General Section: The General section will list out basic information about the plan sponsor like the address, date of business commencement, type of entity, the tax identification number (TIN) etc.
  • Eligibility Requirements: This section pertains to all the rules regarding eligibility requirements. For example: the number of hours an employee needs to work each year to be a part of the pension plan is defined in this section. It could be 500 or 1000, but it is the choice of the plan sponsor and is enlisted in this section.
  • Contribution: This section lists the types of contributions that are available in the plan. A profit sharing plan can have a 401(k) contribution, a safe harbor contribution, or several other contributions. A defined benefit plan will have this same section titled as Benefits, and the defined benefit formula will be listed in this section.
  • Vesting and Forfeitures: Vesting basically means ownership. Not all money contributed to the employees becomes 100% vested immediately. i.e. even though money may be contributed towards an employee, they will not be owners of it. This section will define the vesting rules, and outline other rules regarding the unvested portion. The most common is the 2-20 vesting table which means an employee will be 20% vested each year after completing two years of service.
  • Distributions: A contribution made to a pension plan can be withdrawn only after the specified retirement age, and this section will outline the rules regarding this. The plan can, however, permit some type of distributions categorized as loans or hardship withdrawals.

 

This is a basic idea of a pension plan document. Some companies like Data Air draft standard documents and get it approved from the IRS. Your actuary or TPA can use these pre-approved plan documents to customize the pension plan according to your needs. The IRS issues an opinion letter for a pre-approved plan document. Make sure you receive a copy of this letter when you get a document designed.

Pension Plan documents need to be updated regularly and comply with all pension laws. A profit sharing plan document has to comply with the Pension Protection Act (PPA) of 2006, and the defined benefit plan has to comply with The Economic Growth and Tax Relief Reconciliation Act (EGTRAA) of 2001.

We offer a free evaluation of your pension plan document and can update it to ensure compliance with all relevant rules. Feel free to write to us at info@pensiondeductions.com for any information regarding a plan document.

Some other types of plans:

Safe Harbor 401(k) Plan

A safe harbor 401(k) plan is an ideal choice for a young business owner who is looking to start small and put aside some money for retirement. A traditional 401(k) plan allows you to contribute as much as $18,000 and an additional $6,000 if you are above the age of 50.
If you have employees, the IRS requires you to provide a 401(k) plan to your employees so that they can start saving for retirement. In order to ensure that retirement plans are not too skewed in favor of the highly compensated employees, the IRS requires certain compliance testing to be done. These tests can be complicated and can create a significant over head for you as a business owner. What is worse is that if none of your employees contribute to their 401(k)’s, you can’t either!

This sticky situation can be bypassed if you implement a safe harbor 401(k) plan. This way you can avoid most of the testing requirements of the IRS and can contribute to the plan irrespective of what your employees do.

What is a safe harbor 401(k) plan?

A plan is a safe harbor 401(k) plan if you agree to make certain minimum contributions to your employees in a retirement plan. There are two types of safe harbor plans:

Safe Harbor Non-elective plan: In a Safe Harbor Non-Elective plan, you are required to make a contribution equivalent to 3% of W-2 compensation to all eligible employees.

Safe Harbor Matching Plan: In a Safe Harbor Matching plan you are required to make a contribution only to those employees who contribute to the 401(k) plan. The amount of the contribution will be equal to their 401(k) contribution up to a maximum of 4% of theirW-2 compensation

So which plan should you choose?

The cost of funding the retirement plan will vary significantly depending on which plan you choose. If you estimate that only a few employees will participate in the pension plan then a safe harbor matching plan might prove to be a better option. Anecdotal evidence suggests that employees earning less than $30-40k annually do not contribute to a 401(k) plan. If you have employees with compensations in that range, a safe harbor matching design will reduce your pension funding costs.

However, if you expect all employees to contribute some amounts to the 401(k) plan then the safe harbor non-elective design will prove beneficial.

This is only a basic overview of the safe harbor 401(k) plans and alternative options can be explored that increase allocation to the business owners. Please feel free to get in touch with our office and we shall be happy to provide a free consultation and customized plan design for you.

Profit Sharing Plans

Profit Sharing Plans are a type of defined contribution plans where the employer makes an allocation to the employees and bears no future risk and liability. The allocations are typically a percentage of compensation. There plans were born to eliminate future uncertainty regarding mortality rates and investment returns.
There are different types of Profit Sharing Plans and the one feature that separates them is the method in which the monies are allocated. Based on this, Profit Sharing Plans can be classified into two types:

  1. Traditional Profit Sharing Plans
  2. New Comparability Profit Sharing Plans

Traditional Profit Sharing Plans: In traditional Profit Sharing Plans, all participants receive an equal profit sharing allocation.

Advantage: Mandatory IRS testing may not be required.

Disadvantage: The plan allocation cannot be skewed in favor of the owners or key employees. This is a major disadvantage if you are looking to put aside more money for yourself as the owner of the business.

Who favors this design: A business where every employee contributes the same amount of expertise in the running of the business would favor this design. For example, a small consulting firm operating in a niche segment with three employees would favor such a design.

New Comparability Profit Sharing Plans: The new comparability design was born out of the need to allocate higher benefits to key employees and owners of the business.

 

Advantage: The business owners can contribute up to the maximum permitted amounts each year. This amount is limited by the IRS and is $54,000 for 2016.

Disadvantage: Mandatory IRS testing is required.

Who favors this design: Most firms would favor this design where employees can be segmented in to different classes with each subset contributing different levels of expertise in the operations of the business.

How is the allocation to employees determined?

The allocation to employees is determined by performing cross testing of the contributions/benefits allocated to the owner and key employees against those allocated to the rank and file employees.

This is better explained with an example. Let’s start with the earlier case where the owner wishes to contribute the maximum amount towards his retirement plan. The plan administrator will then allocate 5% of W-2 compensation to all employees and will check if the all the tests required by the IRS pass. The allocation percentage will be increased or decreased till one of the tests fail, and the allocation percentage just before the failure of the test is the minimum required allocation to the employees.

So what exactly are these tests?

Testing includes different types of tests, namely, minimum allocation gateway test, minimum coverage test, and a discrimination test. Trust us, the details are not fun or easy, so leave it to the plan administrator.

Further enhancements to the profit sharing plan

Once you get in to the game of retirement plans, it hardly ever remains simple. If you decide to establish a profit sharing plan, you might have your employees requesting to add the 401(k) option. A 401(k) option will allow employees to start deferring a small amount of their pay into the 401(k) plan. If you are above the age of 50, a 401(k) plan will allow you to defer higher amount, called as a catch up, so it might just make sense for you as well. The maximum 401(k) amount is $18,000 and the catch up is limited to $6,000 for 2016.

Additional Testing requirements

Once you have decided to add the 401(k) feature, additional testing requirements come in to play. This is because the IRS requires testing to be carried out for different money types and between different groups. For example, the deferrals by the owners have to be tested against the deferrals by the employees and similarly for the profit sharing allocations.

A frequent problem arises when the owners and the key employees defer to their 401(k)’s but the employees do not. This results in a failed test. In order to avoid this, the profit sharing plan will have to evolve in to a safe harbor plan. This is achieved by segmenting the total profit sharing allocation into a safe harbor allocation (3% of W-2) and the rest will be deemed as a profit sharing allocation. The safe harbor allocation is 100% vested immediately. This can be explained better with an example. Let’s take the case study above where the business owner wanted to contribute the maximum amount to his own retirement. Since this owner was above the age of 50, an additional $6,000 can be contributed as a catch up.

Once the plan has been designed as a safe harbor plan, the owner and the key employees can defer in the 401(k) plan even if the employees do not defer any money.

This was all about Profit Sharing Plans. If you feel you have even more cash flow and want to put more money aside for yourself, you might want to consider evolving this design into a floor offset design. A floor offset includes a defined benefit plan which can allow contributions as high as $200,000 while keeping the allocation to the employees in the 5-7.5% range.

 

If you are convinced that a retirement plan is an appropriate tax saving instrument for an individual like you, feel free to reach out to us. You can email us at info@pensiondeductions.com and one of our consultants will get in touch with you.