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Defined Benefit Plan Rules

Defined Benefit Pension Plan

A Defined Benefit Pension Plan is a type of a pension plan sponsored by an employer that gives the maximum possible benefit to the participants. It is an ideal solution for someone who is a business owner or a self-employed individual as it can help save for retirement while lowering taxable income.

This article covers the following topics:

Who can set up a Defined Benefit Pension Plan?Eligibility criteria to start a Defined Benefit Pension PlanExamples of a Defined Benefit Pension PlanAdvantages of a Defined Benefit Pension PlanDisadvantages of a Defined Benefit Pension PlanContribution limits to a Defined Benefit Pension PlanDefined Benefit Plan CalculatorDefined Benefit Pension Plan for high income individualsHow to set up a Defined Benefit Pension Plan?What is the deadline to contribute to a Defined Benefit Pension Plan? How to terminate a Defined Benefit Pension Plan? Can you buy insurance in a Defined Benefit Pension Plan?

Who can set up a Defined Benefit Pension Plan?

Any small or large business can set up a Defined Benefit Pension Plan. Even a self-employed individual can set it up as long as there is significant money to contribute to the plan. Typical examples of businesses that set up a Defined Benefit Pension Plan are:

  • Individual consultants who are self-employed
  • People who have a small business and a full time job
  • Small business with only independent contractors
  • A medical practice with a few full time employees
  • Real estate agents with their own agency

Eligibility criteria to start a Defined Benefit Pension Plan?

A Defined Benefit Pension Plan is an employer sponsored pension plan, so this is typically set up by a business. All types of businesses can set it up, however, a prudent decision needs to be made based on the goals and the profitability of the business. Even self-employed individuals and sole-proprietors can start a Defined Benefit Pension Plan as long as the cost justifies the benefits earned.

Examples of a Defined Benefit Pension Plan?

Here are some examples of a Defined Benefit Pension 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 Pension 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.

If you need a tailored estimate, please email us at info@pensiondeductions.com

Please refer to this page for learning more about setting up a Defined Benefit Pension Plan when you have employees: Floor Offset Plans

Advantages of a Defined Benefit Pension Plan

  • Substantial benefits (read money) can be provided and accrued within a short time – even with early – retirement
  • Employers may contribute (and deduct) more than is permissible under other retirement plans such as Defined Contribution Plans
  • Plan provides a predictable and guaranteed benefit, and the benefits are not dependent on asset returns
  • Plan can be used to promote certain business strategies by offering subsidized early retirement benefits
  • The Defined Benefit Pension Plan favors older participants as they are closer to retirement and need to accrue benefits at a faster rate than younger participants.

Disadvantages of a Defined Benefit Pension Plan

  • Administratively complex plan if there are multiple owners/partners in the business.
  • Administration and compliance is expensive, though the cost benefits work out in favor of the sponsor.
  • An excise tax may be applicable if the minimum contribution requirement is not satisfied. However, the risk of this can be mitigated by carefully monitoring the plan and the rate of accrual of benefits.
  • An excise tax may be applicable if excess contributions are made to the plan resulting in over funding. Even this risk can be mitigated by adjusting the investment options periodically based on the investment returns.

Contribution limits to a Defined Benefit Pension Plan?

There is a common misconception that the contribution to a Defined Benefit Pension Plan is limited to $220,000. However, this is not true. The contribution amount to a Defined Benefit Pension Plan is calculated by an actuary and varies based on the age, income and years of service of the individual. These amounts are difficult to generalize and you should reach out to us (info@pensiondeductions.com) if you need an exact estimate. You can use our calculator to estimate the contribution amount in the first year of the plan. Defined Benefit Calculator for Self Employed

Defined Benefit Plan Calculator

Contributions to a defined benefit plan are generally calculated by an actuary based on the age and the annual income of the individual. However, our one-of-a-kind defined benefit calculator can ease the pain for you. Use our calculator above to get an approximate estimate about how much you can contribute each year to the plan.

Defined Benefit Pension Plan for high income individuals

A Defined Benefit Pension Plan is the only plan that will permit large contributions as desired by high income individuals. If the business has been established for several years, the Defined Benefit Pension Plan can be based on past service and annual contributions can be bumped up even further. It is common for someone above the age of 50 and making more than $300,000 each year to be able to contribute $150,000 to $250,000 to the Defined Benefit Pension Plan.

How to set up a Defined Benefit Pension Plan?

Setting up a Defined Benefit Pension 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 Pension Plan. Unlike 401(K) and profit sharing plans, contributions to a Defined Benefit Pension 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 Pension 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 Pension 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 Pension 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 prepare 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 Pension Plan for yourself please email us at info@pensiondeductions.com. We specialize in this area and can provide you with valuable advice and services that could end up saving thousands of dollars and giving a boost to your retirement planning.

What is the deadline to contribute to a Defined Benefit Pension Plan?

Contributions to be Defined Benefit Pension Plan should be deposited before the plan sponsoring entity files its tax returns. The plan sponsor can also file an extension for filing it tax returns, therefore, the final date when the deposits are due is Sept 15th following the close of a particular financial year.

How to terminate a Defined Benefit Pension Plan?

The process to terminate a Defined Benefit Pension Plan can be simple or complex depending on the funding status of the plan, number of participants and if the plan is covered by the Pension Benefits Guarantee Corporation. The PBGC is a government agency that guarantees some ‘basic benefits’ earned by a participant before the plans termination date. We can explain the basic process to terminate a Defined Benefit Pension Plan maintained by a self-employed doctor with no employees. Such plans are not guaranteed by the PBGC which simplifies the process of termination. The plan sponsor, in consultation with the plan actuary determine the funded status of the plan and a resolution to terminate the plan is passed. The plan participant will no longer accrue any further benefit and a decision has to be made if the benefit should be paid out as a Lump sum amount or as an annuity. Typically, for a single person plan, the best option is to take the Lump Sum payment and roll it in to an IRA. This rollover is a tax free rollover and the participant can withdraw money from the IRA as and when required. Withdrawals from the IRA are not tax free.

Can you buy insurance in a Defined Benefit Pension Plan?

Yes, you can buy insurance in a Defined Benefit Pension Plan. However, the face amount of the insurance will have to be calculated by an actuary. There are also several restrictions on the type of the policy that can be purchased. Please reach out to us at info@pensiondeductions.com and we can assist you with insurance.