By now you probably know that defined benefit plans are one of the best available retirement structures. Unfortunately, most people don’t know the rules or how to structure the plans for maximum benefit.
Accumulating $1 million in retirement is tough. So before we dive into the 10 steps, let’s take a look at some of the basics. This is critical to understanding how a plan can work for your business.Quick Navigation
- What is a defined benefit plan?
- How do defined benefit plans differ from defined contribution plans?
- What are the advantages?
- What are the disadvantages?
- Defined benefit plan rules
- Who is eligible for a defined benefit plan?
- Strategies to maximize owner contributions
- What are the tax benefits?
- Third-Party Administrators (TPAs)
- How to choose the right TPA?
- Let’s Look at an Example
- Bottom line
What is a defined benefit plan?
Define benefit plans are retirement accounts that promise a predefined retirement income to their plan participants. The monthly payouts depend on several factors, such as age, employment history, and income level of the plan participant.
It is important to note that the payment method might vary from one company to another. Some organizations follow a conventional annuity structure, where their employees receive monthly benefits. Others might offer lump sum payment at the time of retirement of the employee.
So why should you consider a defined benefit plan? Simply put – no other retirement plan structure allows business owners to get as much money into a plan and still get a tax deduction.
You can’t get this with an IRA, 401k or a SEP. While there can be some disadvantages, they are the best retirement vehicle for high-income business owners.
How do defined benefit plans differ from defined contribution plans?
One of the common confusions among plan participants is about the difference between defined benefit plans and defined contribution plans. Unlike defined benefit plans, employers have no obligations to assume investment risks under defined contribution plans.
In defined contribution plans, employees are responsible for both contributing as well as tracking their investments, although most of the employers offer a small matching contribution, up to 3% of annual salary, to these plans.
401k plans are the most common type of defined contribution plans available in the private sector.
- Income certainty: Defined benefit plans are quite straightforward when it comes to calculating benefits. Most of the employers will provide annual benefit updates to plan participants.
- Financial security through retirement: Since employers assume the risk in defined contribution plans, employees do not have to worry about receiving consistent income. Any income shortfall is covered by the employer, which make defined benefit plans one of the best retirement options available today.
- Supplemental income for those without social security benefits: Defined benefit plans are a relief for retirement individuals with no social security benefits. It provides additional income throughout their retired life.
- Lower management fees: Defined plans come with lower management fees, thereby passing on the maximum gains to the plan participants.
- Limited control over investments: One of the primary downsides of a defined benefit plan is its lack of control when it comes to investments. Since your employer assumes the risk for investments, you’ll not get to choose your investment options.
- Portability issue: Unlike defined contribution plans, you may miss out on benefits or find it difficult to rollover defined benefit plans from one employer to another. The primary intent behind defined benefit plans is to reward employees for their loyalty and years of hard work. If you plan on changing jobs frequently, go for a defined contribution plan instead.
- Transparency is a challenge: Defined benefit plans have a complex tracking process, which lowers the overall transparency of the plan. You may find it challenging to track employer contributions or year-over-year growth.
- Follow the vesting schedule to qualify for benefits: Defined benefit plans often come with a vesting schedule. Some employers spread it across seven years, although it’s not always the case. Some private organizations offer instant vesting to their employees, whereas others follow a standard vesting schedule, such as cliff vesting and graduated vesting.
Defined Benefit Plan Rules
Defined benefit plans are one of the faster growing retirement structures. This is a result of high contribution levels and significant tax deductions.
Most of the requirements revolve around eligibility and funding levels. For example, take a look at the following three rules:
- Include less than half your employees – There is no requirement that you have to cover all your employees. In fact, IRS only requires a 40% coverage. IRS section 401(a)(26) stipulates 2-part tests as follows:
- Employees receiving a benefit under a plan should be a lesser of 50 people or 40%; and,
- “Meaningful” contributions to be made towards the plan.
Those are a few of the basic plan rules that must be followed. Once we have determined employees and eligibility, we can take a closer look at the calculation.
Who is eligible for a defined benefit plan?
An actuary will determine annual contributions based on several factors, including:
- retirement age;
- employee’s life expectancy;
- annual retirement benefit amount;
- interest rates; and
- potential employee turnover.
Once the employee attributes are identified, the company has the option of selecting a formula. For example, any of the following formulas may be used:
- flat dollar amount or unit benefit;
- percentage unit benefit; and
- flat percentage of pay.
A flat dollar amount uses a flat annual amount, for example $1,500. Benefits can be calculated as a flat percentage of pay or an average of salary.
For example, an employee that worked for 25 years will receive 50% of his or her average earnings (on an annual basis) during the three consecutive years of employment with the highest earnings.
A flat amount unit formula uses a flat amount with each unit of service, normally with each year. For example, an employee with 50 units of service would receive a benefit equal to 50 times the unit amount at retirement.
The most popular defined benefit formula is the percentage unit benefit. It considers both the level of compensation and years of employee service. If you want to run your numbers take a look at our plan calculator.
Strategies to Maximize Owner Contributions
Employers have to ensure that the IRS approves of plan actions. The plan must comply with all plan requirements and IRS testing.
So the key is to play within the rules, but still maximize owner contributions. Let’s take a look at some of the strategies and an example.
#1: Use “meaningful benefit” to your advantage
One of the IRS requirements for a valid plan is the “meaningful benefit” to the participant. IRS defines this as an accrued benefit of at least ½% of pay.
While IRS does not specify ½% defined benefit credit itself, it should be large enough to generate a ½% retirement benefit. This will translate to about 2-3% of the current pay depending on employee salary and age. For example, an employee with a $40,000 annual salary has a benefit of about $800 to $1,200.
Age-weighted contributions mean that older employees have larger contribution while younger employees contribute less. The plan cannot benefit small groups of employees. This can invalidate the plan.
Due to defined benefit plan age-weighted capacity, a business owner can eliminate some older employees and include some young ones. This can result in a lower overall employee contribution while still being a meaningful benefit.
#2: Combine with other retirement plans (like a 401k)
An advantage with a defined benefit plan is the combination of other retirement vehicles. In many cases, this is a 401k profit sharing plan.
The 401k plan will provide an extra contribution of $19,500 as an employee deferral ($26,000 if above 50 years old). It also can provide a 25% contribution from a profit sharing plan.
401k plans can be safe harbor plans. The employer makes a safe harbor plan contribution. Profit sharing contributions by an employer for the employee usually range from 5% to 7.5%.
Safe harbor plan make a 3% non-elective contribution. This can subtracted from the profit sharing contribution in the 5% to 7.5% range.
#3: Include your spouse in the plan
Spouses usually provide support in the business even on a part-time basis. They should, therefore, be on the payroll and are subject to a 15.3% employment tax. Being on the payroll allows them to receive benefits just like any other employee.
They can, therefore, make contributions to a 401k as well as a profit sharing plan. A business owner can, therefore, be making a contribution for his/her spouse towards a defined benefit plan. However, the spouse should actually be working for the business.
#4: Hire non-qualifying employees
Another good strategy is to hire employees based on their age and working hours. Defined benefit plan requires that an employee should work more than 1,000 hours and be 21 years or more. Part-time employees and those under 21 years old are, therefore, excluded.
An employer should, however, be careful when using this strategy. Young employees, for example, may lack the necessary business experience. Part-time employees might not have the motivation or commitment.
#5: Don’t forget plan entrance date
The entrance date is the date employees can enroll once the service conditions and age requirements are fulfilled. Entrance dates can be monthly, quarterly, semi-annual or annual.
An annual entrance date will be favorable for business owners wishing to keep transient employees off the plan. It is the most restrictive timeline under the defined benefit plan rules.
#6: Consider a higher wage
Business owners with S corporations benefit from defined benefit plans. They can limit payroll taxes through reasonable owner compensation. They can also avoid double taxation subjected to C corporations.
Contributions to a defined benefit plan depend on age and compensation level. By increasing W-2 salary, the owner can maximize his contribution. This can also be applicable to the spouse. However, high wage translates to higher employment tax and social security contribution.
Social security wage base has limits, for 2018, it is $128,400. The 12.4% social security tax, therefore, cannot go beyond this wage. A business owner can, therefore, increase wages with a minimal increase in taxation.
But before doing this, make sure to discuss the reasonable compensation rules with your CPA.
#7: Consider 3 Year Cliff Vesting
Plans can have a 3-year vesting. Cliff vesting is often the favored strategy. It requires participants to be 100% vested after 3 years of participation. No participant is, therefore, vested until they attain 3 years of service.
In the case of a termination before three years, all the contributions are forfeited. They can then be used to reduce future contributions.
#8: Utilize a life insurance strategy
Defined benefit plan allows for plan assets and future contributions to pay for life insurance premiums for its participants. The life insurance policy will use tax-deductible dollars.
The insurance is owned by the plan and the participants are the insured. All employees must be offered insurance. Seek expert advice on compatibility of life insurance strategies to your plan.
#9: Consider funding for past service
At this point we understand what a great tax planning tool these plans provide. But it gets even better.
Plans can be structured so that they provide for employee “past services.” You can go back from one to five years and examine compensation paid to employees. In the year of set-up, you would then make a one-time contribution for this past service. It’s almost like a “catch-up” contribution.
A business owner can make maximum contributions that will exceed the targeted contribution in that year. This will enable the business owner to get a tax deduction in a year when income will be high.
Let me show you a great example of a past service adjustment we did for a client. The client was 31 years old and had W2 income of $50k. Based on actuarial tables, he could only get approximately $15k into the plan for the current year.
But once we examined his W2s for the last 5 years, we were able to make a past service adjustment that allowed him to get another $105k into the plan. With only a W2 of $50k, he was able to get $120k into a plan. This is just one example. Not that bad.
But there are a couple things to consider. First, you have to include all employees in the plan. This can get expensive if there are a lot of employees. Second, providing for past service will essentially pull from future years. So it will result in high funding in year one and lower funding levels in subsequent years.
What are the tax benefits?
Tax policies encourage retirement savings. Favorable tax treatment on contributions, investment income, and benefits related to income accumulated for retirement.
Contributions by an employer towards a pension plan are deductible in corporate income tax computation. Employees also enjoy tax deferral on personal income until when they receive distributions from their plans. Tax deductions have improved retirement savings for many families in the U.S.
The plans specify that for a plan to qualify for tax deductions, it must meet minimum standards. These standards relate to participation, vesting, and non-discrimination against low-paid employees.
Employer contributions are tax deductible. Employer contributions are also not subject to payroll taxes.
However, the IRS prescribes maximum tax deductible contributions. Contribution limits will vary depending on the type of plan, availability of more than one plan for employees, and whether the plan is top-heavy, meaning that owners and key employees benefit more from the plan.
Third-Party Administrators (TPAs)
A third-party administrator (TPA) is an organization that offers administrative services or pension plans. Managing the administrative tasks is a challenge for employers. Accordingly, they usually contract a third-party administrator to handle much of the hefty administrative work. This allows the employer to concentrate on the remaining investment tasks.
Since not every employer is a financial expert, having a professional service provider manage retirement accounts is an ideal strategy; that’s where third party administrators or TPAs come in.
A TPA is a professional service provider (company or licensed individual) that manages retirement plans for companies. TPAs are responsible for taking care of the day-to-day management, administration activities, compliance, and filing returns on time.
What do TPAs do for employer-sponsored retirement plans?
Let’s dig a little deeper into what TPAs do for defined benefit plans.
TPAs will for example:
- Provide consultation regarding the design of the plan, taking into account the financial goals of the employer as well as employees;
- Create a blueprint example for the operational activities throughout the plan;
- Draft plan documents;
- Work with an actuary for compliance and risk assessment;
- Design contribution and distribution policies of the plan suiting you as well as critical employees;
- Ensure that the plan complies with the rulings mentioned under ERISA;
- Provide tax filing services (5500).
How to choose the right TPA?
Sophistication and understanding of the regulations surrounding defined benefit plans aren’t the only qualities a TPA must possess. Ideally, your TPA should have prior experience in managing similar plans, be able to offer specialization as per your needs, offer competitive products, and communicate essential changes, options to the sponsor as well as the employees.
Experience of TPA
Every organization has specific, different financial goals and obligations towards their employees. A TPA should be able to analyze these goals and offer a suitable plan design, customizations for your business.
- Find out if the TPA has prior experience in providing similar services. Most of the TPAs won’t mind sharing the contact details of their previous clients. Speak with these companies and find out how the TPA helped them throughout the process.
- Make sure to keep your financial advisor in the loop, if not present in these meetings. Your financial advisor can help you understand critical terminology, intricacies of the plan design, and associated expenses.
Need for specialization
Some employers might require specific services for their retirement plans. For instance, a cash balance plan involves accurate, timely compliance filings, requiring particular legal skills. A potential candidate should know his/her way around your specific requirements.
Start by providing critical information to the TPA, such as the size of your business, number of employees, age of employers and key employees, and financial goals associated with the plan.
After sharing these details, find out whether the TPA:
- Understands the administration responsibilities required by the Department of Labor (DOL) and IRS, such as plan design or customizations, installation of the plan, drafting requirements, enrollment procedure, compliance testing, required government reporting, and the need for actuarial services, etc.
- Can handle plan administration along with additional services such as financial advisory or payroll management. Ideally, choosing a TPA that offers specialized services for specific types of defined benefit plans is a better choice in most cases.
Communication is a critical aspect of the whole retirement management process. When choosing a TPA for defined benefit plans, make sure to communicate your requirements, financials, and expectations with the selected candidate or prospects.
Defined benefit plan rules follow a sophisticated reporting, administration, and compliance structure. It’s quite common for employers to be unaware of these intricacies.
It is the responsibility of the TPA to ask the right questions, seek relevant information for filings, and keep involved members in the loop throughout the plan.
Additionally, TPA should maintain proper communication with the employers and employees regarding important contribution deadlines, filings, distribution, or critical plan milestones. Your TPA should work to maximize the financial benefits for you as well as your employees.
Let’s Look at an Example
Peter is a sole proprietor at the age of 60 and has no W-2 employees. He developed a software program for a company and was paid $615,000. Normally, Peter makes about $150,000 every year where he contributes about $40,000 annually to a 401k plan.
Because of the huge income made that year, Peter wants to set up a defined benefit plan to get an extra $200,000 plus into retirement for the current year. In subsequent years, he would want to make lower contributions. Peter has chosen to combine his 401k profit sharing plan with a defined benefit plan.
Peter makes the following contributions:
- Defined benefit plan = $170,000
- 401k deferral = $19,000
- 401k profit sharing = $18,000
- Total contribution = $207,000
Peter, therefore, got a huge tax deduction for his windfall income year and still can maintain lower contributions for future years. Peter can make smaller contributions to the defined benefit plan and chose to not make any contributions to the 401k or profit sharing plans since they are elective.
America’s retirement problem is no secret. A recent survey from Bankrate finds that 1 in 5 Americans save nothing for retirement or other financial goals, whereas another 20% save less than 5% of their annual income. Only 16% of Americans are saving more than 15% of their yearly income.
Saving for retirement isn’t complicated. All one must do is to contribute consistently throughout his employment. The key to having sufficient retirement savings is to start early and stay disciplined. Considering the financial challenges retirees are facing at present, defined benefit plans could be a blessing in disguise.
So what is a defined benefit plan? If you’re guilty of running short on your retirement savings goal, a defined benefits plan is an excellent option to start with. We’ve created this comprehensive guide to help you get a head start in your retirement preparations.
So there you have it. We have covered the rules and tried to make them as simple as possible. If you still have questions, please give us a call and we can answer any remaining questions you may have.