I have talked at length about the advantages of defined benefit plans. There are many.
But what about the disadvantages? These are not often discussed.
Defined benefit plans can be confusing. When I review plans with clients, I make sure to discuss the cons.
I will try to simplify the pros and cons. The table below identifies the top 5 pros and the top 5 cons.
Table of contents
- Defined benefit plan advantages
- Defined benefit plan disadvantages
- A simple look at some of the pros
- A closer look at the cons
- How to make an informed decision
- The Takeaway
Defined benefit plan advantages
- Large Contributions. Plan contributions are often as high as $300,000.
- Funding Flexibility. Each year you will receive a funding range that will scale based on your business income or W2.
- Combining Plans. Approximately 90% of our plans are combined with a 401k plan.
- Tax-Deductible Contributions. They qualify for immediate tax deferral.
- Age-Weighted. Most high earners tend to be older, and this helps.
Defined benefit plan disadvantages
- Conservative Investments
- Non-Elective Contributions
- Higher Plan Costs
- More Complexity
A simple look at some of the pros
Many business owners see the advantages of defined benefit plans and dive right in. But before you do, analyze the downside. Let’s examine some of the advantages.
This advantage is clear-cut. A defined benefit plan allows for much higher contributions compared to other types of plans.
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The plans don’t have annual funding limits like 401(k) plans. The goal is to have a large amount (usually $3 million) at retirement. As a result, the plans allow contributions as high as $300,000 a year to achieve the end retirement goal.
If you are looking to get over $100,000 annually into retirement, you don’t have many other options.
Funding Flexibility: Remember you have a range
Many people assume contributions are fixed. While plans can have set contributions, most plans allow for more flexible funding.
In reality, you have a range. The range itself will result in a targeted amount along with minimum and maximum contributions.
This range offers a lot of flexibility. You can make higher contributions in a high-income year and lower contributions in a down year.
You have more funding flexibility than you might have thought. Also, with each year of service, the range tends to widen.
Combining Plans: Nice way to turbocharge
Not only are you allowed higher contributions to a defined benefit plan, but you can also combine them with 401(k) plans. When you combine the plans, you can turbocharge your contribution. But there is one limitation.
401(k) plans (with profit-sharing contributions) will limit any profit sharing to 25% of compensation. The employee deferral is unchanged.
But when you combine a 401(k) plan with a defined benefit plan, the business is limited to a 6% profit-sharing contribution. This limitation is typically not an issue because the defined benefit plan contribution is so significant it makes up for the reduced profit sharing contribution.
Combining plans is so popular that I would guess that 90% of the plans we do are combos. They allow you to get more significant contributions for a minimal additional cost.
Tax Deductible: The #1 tax strategy
Have I mentioned that plan contributions are tax-deductible? Just like 401k plans, these plans are “qualified” plans. Plan contributions are tax-deductible and then taxed once withdrawn.
However, upon termination, the balance can be rolled over into an IRA or other qualified plan to avoid taxation.
Please review your tax bracket with your CPA. The higher your income and your tax rate, the more these plans make economic sense. This is the reason we do so many plans for people in states like California and New York.
Age-Weighted Funding: It helps to be older
The contributions under these plans are age-weighted, which is a huge benefit for most business owners. But it will be a little trickier for young people.
When we get into our 40s and 50s, we tend to have higher incomes. We also get more focused on retirement. At a young age, we assume we will live forever. Also, we typically don’t have a lot of disposable income to contribute to retirement.
Our typical client is probably around 50 years old with an income of over $300,000. Once people get into their mid-40s, retirement structuring is just as critical as saving money on taxes.
Most plans have a retirement age of 62. Since the plans aim for a retirement balance at age 62, the older we get, the closer to that age we become. For this reason, contributions are much higher for 60-year-olds compared to 30 years olds.
A closer look at the cons
You understand all the pros and why these can be significant tax and retirement structures by now. But what about the downside? Is there a catch?
There are downsides to everything. There are some cons. Bottom line: they are best suited for business owners with consistently high incomes 40 years of age plus.
Conservative Asset Allocation: Not as bad as you might have thought
One belief is that defined benefit plans should hold conservative asset classes. The thought is that you should sacrifice significant investment returns to prevent overfunding.
Well, this isn’t always correct. Plans do carry a stated interest rate credit, which is often around 5%. In theory, the goal is to aim for investment returns that will match this crediting rate.
Higher investment returns can lead to reduced future contributions. The goal is really to limit the volatility.
I often advise clients to use their 401k or IRA to make more speculative investments and keep the defined benefit plan assets more conservative. Since 401(k)s are defined contribution plans, the funding amount is established up front. Once the contribution is made, volatile investment returns do not impact future funding.
Higher Plan Fees: check around
We all know that 401(k) plans are inexpensive to set up and maintain. Many custodians and brokerages will charge a nominal fee (or no fee at all). But they typically will not file form 5500.
There is no doubt that defined benefit plans are more expensive than standard 401(k) plans. This is because the plans need to have an actuary sign-off.
But for the right business owner, these plans are a bargain. Annual administration fees typically run $2,000 to $2,000.
Our typical contribution is approximately $150,000. With federal and state tax rates running 40% or higher, it doesn’t make a six-figure contribution to more than justify any plan costs.
Just don’t establish a defined benefit plan if you only want to contribute $10,000 or $20,000. Stick with a basic 401(k) plan. That is unless your tax bracket is so high that you want to ring out all the tax savings you can.
Permanency: Not as big of a problem as you might think
Defined benefit plans are meant to be permanent plans. But what does this mean? Do you have to have the plan set up for the lifetime of the company?
The IRS has stated that permanent does not mean forever. The plan should be maintained open for at least a few years. They don’t want you to start and stop plans. You should make sure that you have some visibility over the next few years.
But you don’t have to terminate your plan if your income is down in the current year. You can always freeze or amend the plan to lower the interest crediting rate or change the formula. You have options.
One of the best parts of 401(k) plans is that contributions are elective. If your income is down, you don’t have to contribute. But if you have a good year, you can max fund the deferral and the profit sharing. The critical point is that contributions are not mandatory.
But defined benefit plan contributions are generally non-elective. Unless you have an overfunded plan, you will have to contribute.
Even though there is a contribution range, you must make the minimum contribution or assess an excise tax.
Non-elective contributions tend to concern business owners. But they typically aren’t such a big deal. Even in a down year, many businesses have funds on hand that were earned (and taxed) in prior years.
You also have a lot of time to make your contributions. Remember that contributions can be made up to the date you file your tax return (including tax extensions). You have plenty of time to make your contribution even in a down year.
More Complexity: This is a given
The tax-deductible contributions come at a price. The plans can be challenging to understand and administer. You should carefully coordinate with your CPA, third-party administrator, and financial advisor. Most CPAs and advisors don’t know how the plans work.
We have found that the first year can be tough on business owners. But once you get through year one, you should be OK.
How to make an informed decision
- Determine if you should combine with another plan. Defined benefit plans work well in combination with a 401(k).
- Examine the cost of setting up a plan compared to other retirement options. Defined benefit plans will carry higher setup and annual maintenance costs.
- Take a close look at what your plan contributions are over the next several years. Remember that contributions are deemed non-elective so make sure you have the income to support the contributions.
- Make sure you review with your CPA. Your CPA will know your tax bracket and calculate any tax savings.
- Make timely contributions. The IRS requires that contributions be made before filing your tax return.
When considering retirement plans, the goal is to maximize your contribution and save on taxes. A defined benefit plan can be a great plan that offers significant contributions.
Take a look at the defined benefit plan pros and cons to make the best decision for your business.