Easy Defined Benefit Plans Set Up Online
Defined Benefit Plan Guide
How Does a Defined Benefit Plan Work and How to Set One Up?
A comprehensive guide to understanding the Defined Benefit Retirement Plans in detail
A defined benefit pension plan is a type of a pension plan sponsored by an employer that can give the largest possible benefit to the owner with minimal benefits to the employees.
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.
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Go Through Our Comprehensive Guide to Understanding the Defined Benefit Plans
Our article covers the following topics:
- Who can set up defined benefit plans?
- Eligibility criteria to start defined benefit plans
- Examples of defined benefit plans
- Advantages of a defined benefit plan
- Disadvantages of a defined benefit plan
- Contribution limits to defined benefit plans
- What happens to the money in the defined benefit plan
- What is the deadline to contribute to a defined benefit plan?
- Defined benefit plan for high-income
individuals - How to set up a defined benefit plan?
- How to terminate a defined benefit plan?
- Can you buy insurance in a defined
benefit plan? - Compensation for a defined benefit plan
Investments in a defined benefit plan - Defined Benefit Plan Calculator
Who can set up a defined benefit plan?
Every small or large company can set up a defined benefit 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 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 plan?
A defined benefit 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 plan as long as the cost justifies the benefits earned.
Here are Some Examples of a Defined Benefit Plan
Advantages of a Defined Benefit 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
- The plan provides a predictable and guaranteed benefit, and the benefits are not dependent on asset returns
- The plan can be used to promote certain business strategies by offering subsidized early retirement benefits
- The Defined Benefit Plan favours 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 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 favour of the sponsor
- An excise tax may be applicable if excess contributions are made to the plan resulting in overfunding. Even this risk can be mitigated by adjusting the investment options periodically based on the investment returns
How to Set Up a Defined Benefit Plan for Self-employed Individuals?
A certain amount of groundwork is required to set up a defined benefit plan for self-employed individuals. If you have employees you will probably need more data collection to set up a defined benefit plan. However, do not let this discourage you as a defined benefit plan will save you thousands of dollars in taxes.
Guide to Set Up a Defined Benefit Plan
Contact an actuary or a pension consulting firm (like us!)
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. A final calculation needs to be performed by an actuary though. Feel free to email us at info@pensiondeductions.com for quick assistance.
Talk to your CPA
Once you have an initial 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.
For example, your actuary may calculate that you can contribute up to $200,000 to 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.
Draft the Plan Document for 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. You will need to provide the legal name of the company, the EIN, address, and other details. Every defined benefit plan requires a plan document that 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 may also need 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 with 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.
Set up the defined benefit plan investment accounts
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 the 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 overfunding or underfunding the plan. The deposits can be made until you file the tax returns for your business.
File with the IRS
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 into 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. You can also email us at info@pensiondeductions.com.
Set up a defined benefit plan for business with employees
If you are a small business owner with employees you will need to set up a defined benefit plan and a profit-sharing plan together. As explained earlier, contributions to the defined benefit plan can be higher, and you may not want to contribute so much to your employees. Including your employees in the DB plan also brings up the question of minimum contributions each year and the need to fund the plan aggressively if the investments don't perform or produce a negative return. Therefore, we recommend that you set up both plans together and this will allow you to optimize the contribution amounts for yourself. As pension administrators and consultants, we can design and administer these plans. Please reach out to us at info@pensiondeductions.com and we will customize the plan design for you. You should send us an excel sheet with the date of hire, date of birth, compensation, and the number of hours worked for each of your employees. We can then design the plan based on your specific circumstance and tell you exactly how much the business owner can contribute for themselves and what needs to be contributed for the employees. In most situations, we can channelize more than 80-90% of the total contributions to the business owners and the rest will be an allocation to the employees.
Summarizing how to set up a defined benefit plan.
- Contact an actuary or a pension consulting firm (like us!)
- Talk to your CPA
- Draft the Plan Document for the defined benefit plan
- Set up the defined benefit plan investment accounts
- File with the IRS
Contribution limits to a defined benefit plan?
There is a common misconception that the contribution to a defined benefit plan is limited to $220,000. However, this is not true. The contribution amount to a defined benefit 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.
How does the Defined benefit plan calculator work?
As per IRS rules, an individual can make 100% of their compensation in retirement. For example, if a self-employed individual has a business that is registered as an S-Corp. The compensation from the business is a W-2 income of $100,000 and the remaining portion is K-1 income for the business owner.
If we were to apply the IRS rule to this individual, he can earn $100,000 each year from his own defined benefit plan after retiring at an assumed retirement age of 62. The IRS then requires the defined benefit plan to estimate the life span of this individual. There are IRS prescribed mortality tables that are supposed to be used. For example, the mortality table that is used in this case estimates that this participant will live until he is 82. Without any interest rate plays, when the person retires at age 62, he will need $2 million in his account to be able to withdraw $100,000 each year.
The mortality estimates may not play out accurately for a single individual, but this is the concept of the defined benefit plan. This individual will now have to fund for the $2 million pot which is called as the lump sum at retirement.
If this individual is 52, he has 10 years to fund the $2 million, which basically means he needs to contribute $200,000 each year.
This is exactly how a Defined benefit plan calculator works, albeit with a lot of interest rate assumptions. There cannot be a better example of a defined benefit plan than this.
Points to note when using our defined benefit plan calculator
Please note the contribution amount generated by our defined benefit plan calculator is only an estimate. You still need an actuary to calculate the contribution amount for your existing defined benefit plan. The defined benefit plan calculated amount is an estimate only for setting up the plan in the first year. Please do not contribute to an already existing plan using our defined benefit calculator. Feel free to reach out to us at info@pensiondeductions.com if you need any assistance with setting up a defined benefit plan.
Can you buy life insurance in a defined benefit plan?
What is the benefit of buying a life insurance policy inside a defined benefit plan, you may ask? The primary benefit is that the premiums for the policy are paid from the contributions made to the defined benefit plan. The contributions are tax-deductible and this effectively makes the premiums tax-deductible too!
However, the face amount of the life insurance and the premium amounts are subject to maximums calculated by the actuary. The entire contribution of the DB plan cannot be used to pay the insurance premiums. As such, a portion of the contribution will be used to pay the premium and the remaining amount will be invested as a side fund in non-insurance investments. The insurance policy in the plan is typically a whole life policy or universal life policy. The face value of the policy will remain the same irrespective of the type of policy. If you are an insurance agent, feel free to reach out to us to know more about these technical details: info@pensiondeductions.com
Compensation for a Defined Benefit Plan
As it would be clear by now, a defined benefit plan is based on the individual participant's age and compensation. But what is compensation? Typically, earned income (income subject to self-employment taxes) has to be used as compensation. The IRS has very specific definitions of what income can be considered as compensation for a defined benefit plan.
If your business is taxed as sole-proprietorship, you would file a Schedule C for the business. Your Net Schedule C is used for calculating the compensation for the purpose of the defined benefit plan contribution. This is typically done as follows: Net Schedule C after all deductions – ½ FICA – Defined benefit plan Contribution This is only a basic formula and there are ways in which the correct calculation has to be done. Please feel free to email us if you are a sole-proprietor and want to set up a defined benefit plan: info@pensiondeductions.com
If your business is a partnership, and taxed as a partnership, you can consider your K-1 income for calculating compensation for the purpose of a defined benefit plan. The calculation would broadly be along the following lines: Net K-1 income after all deductions – ½ FICA – Defined benefit plan contributions
If your business is a Corporation and taxed as a Corporation, only your W-2 compensation can be used for the purpose of the defined benefit plan. S-Corp owners would also receive a K-1 from the business, but since the K-1 from a Corporation is not subject to self-employment taxes, it cannot be used as compensation for a defined benefit plan.
If your business is a partnership taxed as a corporation, only your W-2 can be used for the purpose of a defined benefit plan.
Compensation for a business that you do not own cannot be used for the purpose of the defined benefit plan. In this case, if you have a full-time job and a business on the side, you can set up a defined benefit plan for the business, but you cannot use compensation from your full-time job for the purpose of the defined benefit plan. "I have a full-time job and a side business. Can I set up a defined benefit plan as I don't really need the income from my side business?" This is a common question that we come across. Many doctors are in this situation where they have a small practice on the side and a full-time job with a hospital. The income from the side business can be used to set up a defined benefit plan and the contributions can be maximized after compensation history has been built in three years. The same rules apply regarding compensation as we have elaborated in the types of compensation above. If the compensation is high enough for the first three years, almost 90% of the income in the business can be contributed to the plan after the three years.
Can you set up a defined benefit plan after age 70?
Some retirement plans cannot be set up after a certain age, however, defined benefit plans do not fall into this category. So if you have a significant amount of income after age 70, you can still set up a defined benefit plan and contribute a large amount of money. The IRS typically requires participants to take a taxable distribution from the plan after age 72 (was age 70.5 prior to the Secure Act passed in Dec-2019). However, the defined benefit plan can utilize unique vesting schedule options to suspend the distributions for a few years. This will give you the option to defer taxes in high-income years and roll over the remaining balance to an IRA.
Investments for a defined benefit plan
Investment ideas for large defined benefit plans are totally different from investment ideas for small defined benefit plans that are typically set up for the benefit of business owners or sole-proprietors.
Think of a defined benefit plan like a bucket. One can fill this bucket either with contributions or with investment appreciation. Most business owners set up defined benefit plans with the goal of getting large tax deductions. If this is the goal, one's rate of investment return should be as low as possible so that the bucket is not filled up by investment returns.
What happens to the money in the defined benefit plan?
A trust account is opened in the name of the defined benefit plan. This account could be opened with any institution like Fidelity, Charles Schwab, TD Ameritrade, etc. The contribution money is deposited into the account as and when cash flow is available. The plan sponsor is also the trustee (in most cases) for the investments in the plan. The trustee can decide to invest the money in any exchange-traded product like a stock, bond, mutual fund, ETF, etc.
Source: https://www.pensiondeductions.com/comprehensive-guide-to-defined-benefit-plan/
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