How much can you save in a Defined Benefit Plan? If you’ve read our prior posts, you know that Defined Benefit Plans allow for substantial, tax-deductible retirement contributions. In fact, for high-income business owners, a Defined Benefit Plan (“DB Plan”) is often an ideal vehicle.
Just how much can you save in a Defined Benefit Plan? What factors impact this amount? We’ll cover these answers in today’s post.
A Defined Benefit Plan provides massive tax savings to a business owner – more than any other retirement plan.
How are these tax savings realized? First, employer contributions are tax-deductible. Second, once contributed, assets grow tax-deferred. Third, at retirement, a business owner may rollover assets to an IRA, continuing tax deferral. It isn’t until distribution that amounts are taxable. The tax rules for a Defined Benefit Plan are similar to those for a 401(k). However, the annual contributions to a Defined Benefit Plan may be significantly higher (as much as $250,000+).
In exchange for substantial tax advantages, a business owner with a Defined Benefit Plan must comply with applicable regulations. One of the requirements is that benefits must be limited to a specified amount. For 2024, the lifetime annuity payable at age 62 is $275,000. This translates to a single sum distribution of up to $3.5 million per person. For a business that employs both the owner and spouse, this amount may double to approximately $7.0 million!
The Defined Benefit Plan limit may be adjusted for several factors. These factors include the age of payment, compensation history, and length of service. The year of distribution also matters because the Defined Benefit limit is generally indexed for inflation. We’ll discuss each of these items in more detail.
How much you can save in a Defined Benefit Plan depends on the age when payment is received. For example, if payment is made before age 62, the limit is reduced. The idea is that because assets are expected to grow over time, a balance paid and rolled over at an earlier age is more valuable than a balance paid and rolled over at age 62. The earlier the age, the steeper the reduction. For example, for someone who receives payment at age 50, the single sum 2024 payout limit is approximately $1.9 million.
The Defined Benefit limit is impacted by how long the business owner is in the Plan. Time in the Plan is often different than how much service the owner has with the business. For example, let’s say an owner started the business on 1/1/2016 but the DB Plan is not effective until 1/1/2023. How much service in the Plan would the owner have on 1/1/2024? In this case, the owner would have only 1 year in the Plan because the Plan was not effective until 1/1/2023.
Why is time in the Plan important? Well, because the $3.5 million limit, after it is adjusted for payment age, is prorated when there are fewer than 10 years in the Plan. For instance, if a business owner only had 5 years in the Plan, then the limit would be cut in half.
Once you have calculated the Defined Benefit limit to reflect the age at payment and time in the Plan, you calculate a separate Defined Benefit limit based on compensation. The final limit is the lesser of these two “preliminary” limits.
The compensation-based Defined Benefit limit uses a 3-year compensation average. For a 2024 payout, if this compensation average is less than $275,000, a commensurate adjustment may be made. As an example, if the 3-year compensation average is $137,500 (half of $275,000), then the compensation-based payout limit would be half of the $3.5 million for a 62-year-old.
Once the compensation-based limit is calculated, it is prorated if the business owner has fewer than 10 years of service with the business. In the prior example, where an owner started the business on 1/1/2016 and the Defined Benefit Plan is effective on 1/1/2023, the owner would have 8 years of service with the business as of 1/1/2024. In this example, the compensation-based limit would be multiplied by 8/10 or 80%. This amount would be compared with the “first” limit adjusted for payment age and time in the plan. The final limit would be the lesser of the two amounts.
As mentioned, for 2024, the annual lifetime amount payable at age 62 is $275,000. However, in almost all instances, small business owners have their Defined Benefit assets paid in a single sum and rolled over to an IRA. To convert a lifetime payment into a lump sum, an actuarial calculation is done.
We will discuss how actuarial present values are calculated in a future post. For now, it’s sufficient to say that the lump sum value is a function of the interest rate and mortality table used, both of which are prescribed in Defined Benefit Plan regulations. Additionally, the Defined Benefit Plan Document defines the interest rate and mortality table used for this purpose. The actuarial present value is calculated using both sets of assumptions. The final DB Plan lump sum limit uses the smaller of the two amounts.
How much can you save in a Defined Benefit Plan? In short, at age 62, you can receive a payment of nearly $3.5 million in 2024.
As discussed, this amount may be adjusted based on several factors. While the explanation of these factors has been simplified, you now should have a better understanding of how much you can save in a Defined Benefit Plan.
Regardless, Defined Benefit Plans provide significant potential for business owners who want to reduce their taxes and save quickly for retirement.