January 3, 2019
What is a Defined Benefit Plan? How do Defined Benefit Plans Work? Would a Defined Benefit help you and your business? These are some of the questions we will be answering in this post.
If you haven’t seen the Defined Benefit Plan Overview, consider starting there. In this post, we will provide additional detail regarding how Defined Benefit Plans work.
In general, we can divide retirement plans into two categories: Defined Benefit (“DB”) and Defined Contribution (“DC”).
401(k) and Profit Sharing Plans are examples of DC Plans.
Defined Benefit Plans are less common. To help you understand how Defined Benefit Plans work, we’ll start with the more familiar 401(k) Plan and build from there.
As mentioned, a 401(k) Plan is a type of DC Plan. Like the name suggests, DC Plans are “defined” based on the contributions made rather than the ultimate retirement benefit. For example, with a 401(k), two employees who are the same age and make the same contributions would likely have different retirement balances.
Why is that? Well, because the account balance is not only a function of the amounts contributed. The balance also depends on the investment returns. If one employee invested in an aggressive portfolio and another invested in a conservative portfolio, the account balances would probably be very different. The balances would depend on the investments in the portfolios.
By contrast, Defined Benefit Plans work using predefined formulas. In most cases, investment returns do not impact the final benefit. That’s because the employer adjusts annual contributions, reflecting asset levels, such that retirement benefits are funded.
For the high-income business owner, the Defined Benefit structure creates an opportunity. By defining a large retirement benefit and then making tax-favored contributions to fund that benefit, Defined Benefit Plans have the potential for significant contributions. The allowable contributions are a function of the predefined benefit and the owner’s age. The larger the defined benefit and the shorter the retirement horizon, the greater the contributions needed to fund the benefit. More on this later.
As discussed, Defined Benefit Plans work using predefined formulas. We can define a benefit formula in many ways. For salaried employees, it is generally based on compensation and length of service. In this scenario, two employees with the same length of service, same compensation, and same retirement age would have the same retirement benefit. How the market performed during their period of employment wouldn’t matter.
A simple example of a DB formula would be 10% of pay multiplied by years of service. This amount would be payable starting at retirement and would continue until the employee is deceased. As an example, for someone with 10 years of service and $5,000 of monthly compensation, the retirement benefit would be $5,000 per month (10% x 10 years x $5,000 compensation). Generally, small business plans allow a lump sum payment in lieu of a monthly annuity. The lump sum equals the Actuarial Present Value of the expected payment stream. The business owner can rollover the lump sum to an IRA.
Like 401(k) Plans, Defined Benefit Plans are employer-provided. By contrast, IRAs, or Individual Retirement Accounts, are not employer-provided – they are individual accounts.
Defined Benefit Plans may be adopted by a business of any size. This includes one-person businesses, where the business provides the Defined Benefit Plan to its only employee – the owner.
In general, small businesses adopt Defined Benefit Plans to maximize tax-favored contributions to the owner. Benefits also generally must be provided to non-owner employees, but the Plan may be designed to allocate the majority of benefits to the owner. Rules around allowable benefit disparity between owners and non-owners will be covered in a future post.
Similar to the 401(k), Defined Benefit Plans for small businesses are usually Qualified Plans.
For a retirement plan to be a Qualified Plan, it must meet the requirements of Internal Revenue Code §401(a). This Code section addresses a number of items such as benefit limits, benefit protections, and the permissible disparity between highly and non-highly paid employees. Future posts will address these requirements in more detail.
By complying with these regulations, Qualified Plans receive favorable tax treatment not available to Non-Qualified Plans. For example, contributions to Qualified Plans are tax-deductible. Once deposited, funds grow tax-deferred. At retirement, the business owner is able to elect a lump sum distribution from the Defined Benefit Plan and rollover that amount to an IRA, where taxation is deferred until distribution. These tax savings are substantial, making the additional compliance worth the effort.
As mentioned previously, because Defined Benefit Plans work using predefined formulas, large deductible contributions are possible.
As an illustration, take a business owner who is funding towards the 2022 maximum lump sum benefit of $3.2 million. Since regulations permit the owner to accrue this amount in only 10 years, annual tax-deductible contributions of $250,000+ for 10 years could be deposited to fund this benefit. If the business owner’s spouse is also an employee, the annual contribution could potentially double to $500,000+. Compare these figures with the 401(k) and Profit Sharing contribution limits of only $27,000 and $67,500 per year, respectively, including catch-up contributions.
What’s more, employers often couple Defined Benefit Plans with 401(k) and Profit Sharing Plans to further increase the maximum deductible contribution. Regardless of the high contribution limits in a Defined Benefit Plan, ultimately, the Plan is designed with an expected contribution level consistent with the owner’s retirement and business objectives.
Because Defined Benefit Plans have significant tax advantages, the IRS imposes limits on retirement benefit amounts, as well as the compensation used to calculate those benefits. These maximums have the effect of limiting tax deductions attributable to owners and other highly compensated employees.
For example, regardless of the actual compensation paid, the 2022 compensation used to calculate benefits can be no more than $305,000 per year. The IRS indexes this amount each year so that it increases with inflation.
In addition, Defined Benefit Plans must limit the retirement benefit amount. These limits are defined in Internal Revenue Code §415(b). Additional detail will be provided in a future post. For now, it’s sufficient to say that the 2022 benefit limit is approximately $3.2 million for a lump sum payable at age 62. Limits may be adjusted for the employee’s retirement age, compensation, length of employment, and plan participation, as well as the applicable interest rates and mortality table. Like the compensation limits, benefit limits are indexed for inflation.
Now that you know how Defined Benefit Plans work and how they can benefit you, let’s see if a Defined Benefit Plan makes sense for you.
Whether a Defined Benefit Plan is the right fit depends on a number of factors, including your age as the business owner, your compensation level, and the amount you would like to contribute each year. The number, ages, and compensation level of your non-owner employees, as well as your ability to make annual contributions, is also important.
As a simple rule of thumb, a Defined Benefit Plan works best for business owners who are at least 35 years old and would like to contribute $60,000 or more per year for at least five years.
Age matters, because if the business owner is too young, the maximum contribution amount may be lower than other available retirement plans. That’s because, in a Defined Benefit Plan, you are funding towards a predefined benefit, and smaller contributions are needed to fund that benefit when the retirement horizon is longer. That’s why we generally recommend that the business owner be at least 35 years old.
As mentioned, the annual desired contribution is also important. If the owner wants to contribute less than $60,000 per year, another option such as a Profit Sharing Plan or SEP may be a more cost-effective vehicle for achieving that objective. However, if the owner’s earned income is less than $244,000, Profit Sharing and SEP contribution limits may be further reduced (contributions are limited to 25% of earned income). Stand-alone Defined Benefit Plans do not have this deduction limit, so a higher deduction may be available using a Defined Benefit Plan when income is below this threshold.
In addition, benefits must be provided to non-owner employees, so, in general, fewer employees means a lower cost. When evaluating whether a DB Plan makes sense, the cost of providing non-owner benefits must be weighed against potential tax savings. A good rule of thumb is 10 or fewer non-owner employees to every owner. Thus, if there were 2 owners, the rule of thumb is 20 or fewer non-owner employees for a Defined Benefit Plan to make sense.
Finally, the ability to make annual contributions is necessary. In most years, Defined Benefit Plans require contributions, so the business should be stable enough to meet that obligation. We can design the expected level of contribution to meet business objectives. Even so, the business owner should plan to make annual contributions.
In reality, whether a Defined Benefit Plan works for you will depend on a variety of factors. This is why we offer a complimentary consultation to assess your particular situation.
If you think a Defined Benefit Plan may benefit you and your business, here is the process we follow for helping business owners adopt a Plan (we will cover these topics in more detail in the future but will cover them at a high level in the sections below):
First, during our free consultation, we get a better understanding of your objectives, your business, and your employee demographics. This helps us determine whether a Defined Benefit Plan may be a good fit for you. If you are likely to benefit from a Defined Benefit Plan, we request the employee census data. This information allows us to “crunch the numbers” and propose a plan design.
Second, based on your business and retirement objectives, we propose a Defined Benefit Plan design. The design involves proposing plan provisions (e.g., benefit formula, retirement age, actuarial assumptions) such that the maximum deductible contribution meets your needs. This step also considers the expected minimum required contributions in future years and the estimated cost of non-owner benefits. We tweak the design based on your feedback.
Third, we draft the Plan Document and Summary Plan Description (“SPD”). The Plan Document describes how the plan operates, including the plan provisions decided upon during the proposal stage. The SPD is a shorter summary of the Plan Document.
Fourth, the employer formally adopts the Plan. This involves signing the applicable documents.
Fifth, we apply on your behalf for a Trust Identification Number. The employer or the employer’s financial advisor uses this number to open the Defined Benefit custodial account.
Sixth, the employer distributes the SPD and other participant disclosures to employees covered by the Plan.
Seventh, the employer funds the Plan. For contributions to be deductible for a calendar tax year, they are due by the date of your business filing (but no later than September 15th of the following year).
Defined Benefit Plans require annual administration. Administration includes actuarial calculations, government filings and participant disclosures.
Actuarial calculations, including a valuation of the Plan, must be completed each year. As a part of this, the Enrolled Actuary determines the maximum deductible and minimum required contributions to ensure that contributions deposited will be fully deductible and are adequate to fund the Plan.
Next, these actuarial calculations, along with other plan information, are filed with the appropriate government agencies using the Form 5500 Series. Depending on the Plan and events that occurred during the year, other filings may be required.
Lastly, participants in the Plan must receive Plan-related and individual-level disclosures each year.
Eventually, the employer terminates the Defined Benefit Plan. This may occur because the owner is retiring, business and/or employee needs have changed, or the Plan is no longer affordable.
The employer must complete a number of steps as part of the termination process. We will provide more detail in a future post.
Now that you’ve read this post, you have a better understanding of how Defined Benefit Plans work. You also know that a DB Plan can significantly reduce your taxes and help you quickly save for retirement. Lastly, you know if exploring a Defined Benefit Plan makes sense for you and your business.
How can we help? Do you have further questions regarding how Defined Benefit Plans work? If so, please let us know. We would be happy to assist you.