The defined benefit plan calculator below will give you an estimate of how much you can contribute to a plan. Just enter some basic information regarding your age and income and the calculator will generate a PDF illustration. You are done in less than a minute!
Defined Benefit Plan Calculator
First a few comments about the calculator
As stated before, the defined benefit plan calculator will give you a basic illustration. It is not meant to be exact and final contributions can only be accurately calculated by an actuary.
But it will give you a good idea of contribution levels. Many business owners just want to get an idea of how much they can contribute without going through a formal process. In fact, most CPAs and financial advisors don’t understand how the plans work. This is a great place to start.
If a company has employees then we can run a couple scenarios and provide separate illustrations. However, our goal is always to get at least 90% of all retirement benefits accrued to the owners.
If you are a financial advisor or CPA, you can include your name at the top of the report. The report can then be presented to a client.
If you are an S-corp or C-corp, only your W-2 wage amount should be included in the calculator. If you are a sole proprietor then just include your estimated business net income.
The calculator will generate a personal illustration report. It comes in a PDF format that will give you standard defined benefit plan contributions and maximum contributions. You are then able to download the PDF.
Our illustration combines a defined benefit plan with a 401k and a profit sharing plan. The calculation is generated in less than a minute!
So hopefully by now you have a custom defined benefit plan illustration. But how much do you really know about these plans? What are the pros and cons and how do the plans actually work? Well, let’s take a step back and identify some key issues relating to the plans.
So how do the plans work?
Defined benefit plans are not very common in the private sector. In fact, statistics show that only 4% of workers in the private sector have a defined benefit pension plan. About 14% of private companies have combined both defined benefit and defined contribution plans.
The public sector prefers defined benefit plans, with 88% of employees being covered under a defined benefit pension plan. A good reason for this is that in the private sector, the employer contributes to the plan and bares the risks associated with overall funding. Accordingly, they may be deemed too risky. But in the public sector, employees can often contribute to their own defined contribution plans as well.
Defined benefit plans also work well for employers and key employees with high compensation. An annuity is calculated as a percentage of earnings. If the compensation is high then the retirement benefit is also high. Small employees with small earnings have very little retirement benefits to smile about.
However, we have seen an increase in defined benefit plans in recent years. The main reason is that small business owners (including sole proprietors and single shareholder S-corps) have realized that the plans become a great way to secure their retirement. As long as employee contributions can be minimized, large personal contributions are possible.
With 401K plans, employees will invest personal pre-tax dollars into the market in anticipation of a decent rate of return. But the risk is on them. In contrast, a defined benefit plan, has an established rate of return that is monitored by the company and the plan actuary.
Business owners can use a plan to maximize their contributions and also to retain and reward important employees. It often acts in place of a bonus that would be subject to immediate income tax. Employees may not see the immediate benefit (like a bonus), but they tend to be a key ingredient in employee retention.
Plan illustration basics
Let’s discuss some of the plan basics. There are some critical issues that should be understood upfront. These plans can certainly be more complex than a standard 401k plan. But the benefits can not be understated.
The defined benefit plan is a type of pension plan and is different than your basic 401k plan. Let’s take a look at some key points:
- They can be used for a company of any size including personal solo plans (S-Corps, C-Corps, partnerships, and solo proprietorships).
- They are more complex than a 401k plan, but offer far reaching benefits.
- Since they require an annual actuary certification, they can me more expensive to set up.
- Plan monitoring is provided by a third-party administrator who will work with the actuary and maintain compliance with the IRS.
- Yearly contributions made by the employer are required for a target retirement income. These amount will vary on an annual basis.
- An actuarial valuation must be done each year. If a funding shortfall is found, additional funding may be required.
- Requires an in-depth Form 5500 to be filed with the IRS and DOL each year as long as the plan is in place.
- Tremendous tax savings for owners who would otherwise not qualify for a QBI tax deduction due to income restrictions
- Can be combined with other plans, such as IRA or 401(k)
For 2019, the maximum income receivable under the defined benefit plan is $225,000. Annual contributions are made to fund the income requirement. Contributions are completely tax deductible up to IRS limits.
As a general rule, if a company hires employees, they must offer the same plan to the individuals (subject to discrimination testing). It is funded entirely without employee contributions even if it is a personal defined benefit plan.
In a defined contribution plan, the benefit upon termination of employment is the vested percent of the participant’s account balance. The vested percent increases with service, generally reaching 100% by the seventh year.
In a defined benefit pension plan, the account balance is replaced by the concept of an accrued benefit. A participant accrues (or earns) a portion of his projected benefit at retirement each year that he is in the plan.
Personal Defined Benefit Plan Calculator
For example, a participant who will be in the plan for ten years at retirement might accrue one-tenth of his benefit for each year of plan participation. Assuming a projected pension of $100 per month, this participant would have an accrued benefit of $10 per month after the first year, $20 per month after the second year and so forth. Vesting is then applied to the accrued benefit. These amounts are not considered in our calculator or illustrator, but can be included in the actuary calculation.
When a participant terminates, his pension benefit calculation is defined as a certain amount payable at retirement age as a personal annuity. An actuary determines the present lump sum value of that annuity. If the current value is less than $5,000, the participant may generally take the distribution in cash. This is either as a rollover or a taxable distribution. If the value is more than $5,000, the default form of distribution is a joint and survivor annuity.
A joint and survivor annuity pays a monthly amount during the life of the participant and a reduced amount (usually 50%) upon the death of the participant for the remaining life of the spouse. Both the spouse and the participant must consent in writing to waive this form of benefit calculation if the participant wants to take a lump sum or other form of annuity.
Defined benefit pension plans can offer loans to participants. The maximum available loan is a calculation based on the lump sum value of the vested accrued benefits of the participants (as opposed to the account balance calculator). In-service withdrawals and hardship withdrawals are generally not allowed. The personal defined benefit plan calculator will not track loans.
Terminating a plan?
In many situations, business owners are so eager to fund a plan that they don’t realize the permanency of the plans. Defined benefit plans are not elective. So you cannot start and stop the plan as you see fit.
Companies are often hesitant to adopt plans because they are a bit more expensive and more complex to understand. Plus, they do require the company to commit to annual funding requirements. This can scare away even the most cash rich companies. But the tax savings will often outweigh any other downsides.
The IRS assumes the plans are permanent and can only be changed or terminated based on certain situations. The main hurdle to closing a plan is demonstrating “business necessity.” The owner cannot simply just say that they wish to terminate the plan for no apparent reason. This typically will not go over well with the IRS.
A valid reason would be an unforeseen reduction in profits, change in ownership structure or a significant change in cash flows. On occasion, the IRS has allowed termination as a result of the adoption of different retirement plan. A company may be able to demonstrate that a different plan is more suitable for the business.
The IRS also states that a plan should be in place for a “few years”. But what does this mean and how is it defined? In general, the IRS will not question a termination that occurs at least 10 years after the original plan adoption. In practice, companies that terminate plans in the 5-10 year range have not faced much push back from the IRS. This can be assumed up fron inthe illustrator.
So what is the employer’s responsibility?
The employer has many responsibilities when it comes to administering plans. The main responsibility is to invest the plan assets for the benefit of the employees. The company will be forced to make up the shortfall if investment returns are lower than anticipated. To avoid any complications, the company will need to consider three investment issues:
- Asset diversity. The allocation of plan assets will have a large impact on overall plan funding.
- Interest rate assumptions. Planned and expected interest rates will play a big part in the plan returns. Higher assumed rates may minimize the company’s funding requirements. Conversely, lower rates may require the company to step up funding efforts.
- Dealing with plan shortfalls. As with any investment, if expected returns are less than anticipated, the company may have to deal with a shortfall. This is not the case with certain other retirement plans that allow for elective contributions. In some situation, shortfalls can be amortized over future years. But this issue should be discussed with your CPA and third party administrator.
Defined benefit plans require solid investment returns to benefit participants. Investment allocations should be analyzed and revised on an annual basis. If not, unexpected shortfalls can occur.
Companies should avoid unanticipated large contributions as this can result is a strain on cash flows. Thorough planning and research should happen with important decisions regarding: shortfalls, asset allocation, and interest rates.
At the end of the day, defined benefit plan rules are more extensive than those of defined contribution plans. But be careful. If an employer owns several businesses, it can be a significant complication. The combined businesses will likely have to cover all employees (with some limitations). The IRS will typically view the businesses as a “controlled group.” If the owner has multiple business interests, an upfront discussion should occur with the CPA and plan administrator.
The bottom line on a defined benefit plan illustrator
The good news is that defined benefit plans will allow for much higher contributions compared to 401(k) plans. This higher amount will grow as employees age and have pay increases. This allows participants to accumulate large tax-deferred amounts.
Defined benefit plans allow high income earners to maximize contributions and accumulate significant retirement funds. In addition, they are afforded some very large tax deductions.
But don’t take it solely from us. Take a look at the defined benefit plan calculator and see for yourself the large contributions available to you. When combined with a 401k (including a profit sharing component) it is tough to beat these plans.