What if you could funnel an additional $3 million into retirement and get a tax deduction in the process?
That’s exactly what many of our clients are doing with a solo defined benefit plan. If structured correctly, this is one of the best tools a business owner can use to accelerate retirement savings.Quick Navigation
- A Single Participant Plan
- How a Solo Defined Benefit Plan Works
- A One Person Plan for Independent Contractors
- So Who is a Good Candidate?
- 1099 Rules on Withdrawals and Rollovers
- Solo Defined Benefit Plan Contribution Limits
A Single Participant Plan
401k plans are common to many self employed business owners. Contributions are made by the employee and the business can add a profit-sharing contribution. A tax deduction is available for both contributions.
However, a one person defined benefit plan works differently. Contributions are made by the employer to the participant’s retirement account based on calculations by an actuary. A one person defined benefit plan provides a lump sum amount or a specified annuity payment at retirement age.
How a Solo Defined Benefit Plan Works
Employer provides plan documents offering an interest contribution to be made to an employee account on top of the regular pay credit contributions. Some prefer this form due to less involvement while others prefer dictating their own way to invest, which is either a positive or negative aspect of a defined benefit plan based on your preferences.
Defined benefit plans thus have a steady growth free from stock market fluctuations. Interest contributions range from 4% to 5% annually of the contributed amount. Here you will find a few examples.
Investment firms assist business owners to manage defined benefit plan funds. These funds are typically invested in mutual funds and other liquid investments. In some cases, life insurance can be utilized.
The investment firm ensures the objectives are achieved. Defined benefit plans are advantageous to employees; they have little or no involvement in the investments while the employer is tasked with everything including risks involved with the investments.
Advantages under a solo defined benefit plan include:
- A full tax deduction for amounts contributed.
- The ability to combine with defined contribution plans like 401ks.
- Contributions are generally based on a percentage of compensation.
- The annual rate of return is based on actual returns or on an interest rate credit that is specified in the plan document.
- Solo pensions are great for 1099 independent contractors.
- IRS has established rules that limit exploitation of defined benefit plans including contribution limits. Because of tax advantages on contributions, individuals could exploit this area by making higher contributions, limits are therefore important to determine the tax deduction one can utilize.
A One Person Plan for Independent Contractors
Defined benefit plans do not set specific limits (see our dummies post). Every employee has a different limit based on certain situations. Age is the main limit determinant, where older employees have higher limits as they near retirement compared to younger employees.
This allows them to recover their saving years within a short period of time. Length of service, with the company, the position held and job responsibilities also determine the contribution limits.
A solo defined benefit plan allows an individual to take advantage of a combination of both 401k and profit sharing plans. These two plans have varying contribution limits subject to yearly set limits and rules.
By combining the three plans, a participant enjoys a higher aggregate annual limit. This is a huge advantage for heavy retirement saving as well as tax deductions for 1099 contractors.
So Who is a Good Candidate?
Professional service businesses are the best candidates for a one person defined benefit plan. They have less overhead and higher earnings power which puts them in a good position as compared to other businesses. Some professional service businesses that could take advantage of a one person defined benefit plan include:
- Attorneys and law firms
- Accountants and CPAs
Historically, law firms and medical practitioners have been the best candidates of a one person defined benefit plan. Generally, it is because of their high incomes.
1099 Rules on Withdrawals and Rollovers
The goal of a single participant benefit plan (or solo pension) is to provide a secure retirement. Early withdrawals before retirement are subject to penalties. Withdrawal are allowed if the entire amount in the account is withdrawn. These amounts are taxed as ordinary income.
Any withdrawal made less than the account balance has a 10% penalty on top of taxes on the amount withdrawn. Just make sure that you discuss any withdrawals with a defined benefit plan TPA.
How to structure a solo or one person defined benefit plan:
- Verify that you have no qualifying or eligible employees
Remember that you cannot have any employees that work over 1,000 hours and who meet the entrance rules. If you have qualifying employees, then you will have to make a meaningful contribution for them.
- Determine your proper funding
You can set up a plan to allow for a first year flat dollar amount. Then in subsequent years it can vary depending on your W2 compensation.
- Sign the plan document
Your administrator will review and complete the plan document for you. They can also customize it for you based on your business requirements.
- Determine who will be your custodian
You will be the trustee of your own plan so you can manage your own investments. Most plans can be used with a variety of custodians.
- Fund the plan by the deadline
Remember to allow yourself plenty of time to set up the plan and get it funded by the date you file your tax return. Don’t miss the deadline!
Solo Defined Benefit Plan Contribution Limits
In case of a change in career or job, defined benefit plans can be rolled over to an IRA for continuity in contribution. A rollover can also occur when a company terminates a plan based on fundamental business change.