For the self employed individual who earns more than $200,000 each year, the defined benefit plan might be the only option worth considering, despite the complexity involved. The pros could outweigh the cons by a huge margin and hence we believe that self employed individuals need to delve more into defined benefit plans.
Older business owners who have significant cash flow can contribute an amount between $100,000 - $250,000 each year. The entire contribution will be pre-tax, which will also lead to significant savings on taxes. If you are a self employed individual and are intrigued by what you can contribute each year, please use our defined benefit calculator.
If you want to educate yourself some more before getting to the numbers, please read on.
So what exactly is a defined benefit plan?
We have a technical definition here, but in lay man terms, it is a pension plan that promises to pay a certain benefit after retirement. For the self employed individual, the benefit is generally a dollar amount. This dollar amount will be based on your highest compensation that you have received in the past years. For example, let's say your Schedule C income has been $200,000 for the past three years. The defined benefit plan will use this number less the FICA taxes as your compensation. Let's also assume that you wish to earn the same amount each year after you retire. With these inputs and using a standard mortality estimate, the pension actuary will calculate how much money the plan needs to have at the retirement age of 62/65. Once this amount has been determined, the actuary can also estimate what needs to be contributed to the plan each year based on the age of the self employed individual.
Is there a limit to what we can contribute to a defined benefit plan?
Yes, the IRS limits the total amount of money that can be accumulated in a defined benefit plan. A self employed individual with the highest permissible compensation ($215,000) and at least 10 years to retirement can accumulate a maximum of $2.6 million in the plan. In addition to this, there are limits on what can be contributed each year.
What if the contribution per year is too high?
The defined benefit plan contributions can be lowered in any given year by reducing the 'benefit'. This benefit is stated as a formula. In the above example, the formula used is 100% of past three year's compensation. With a simple amendment this formula could be reduced to 75%, or 50% or the plan could simply be frozen.
Is there any annual reporting that needs to be done?
Yes, a pension plan is required to file its return with the IRS just as all individuals and corporations. This is known as a Form 5500 SF which will be filed by the third party administrator hired by you. It is a simple three page document that declares the value of the assets in the pension plan as of the beginning and end of the year.
What happens to the plan when I reach my retirement age?
Let's assume you reach the age of 62, which is the plan's assumed retirement age and you decide that you do not want to continue working any more. Your defined benefit plan can be terminated and the entire proceeds accumulated in the plan can be rolled over in to an IRA. This is the preferred method than purchasing an annuity in the plan so as to eliminate the need to keep the plan active. Withdrawals from the IRA can be done as needed or an annuity can be purchased.
Can I keep the plan active after reaching my retirement age?
Yes, let's assume that you still want to keep working after reaching the retirement age and want to avail of the tax deductions. You can keep the plan active until you have accumulated the maximum permitted amount in the plan.
If you think this is too much to comprehend, we would suggest you leave the technicalities to an actuary. Use our defined benefit calculator to estimate your contribution amounts to determine if a defined benefit plan makes sense for you.
If you are a small business owner with a few employees read about the floor offset defined benefit plan option for you