Defined Benefit Plans Offer Numerous Perks
(This is the first of a series of articles on pension plans. In the next article, Guy McPhail will examine 401K plans.)
Most small business owners would like to reward steadfast employees by offering a retirement plan as a benefit. And, of course, they are interested in socking away money to fund their own future financial independence. While defined contribution plans such as profit sharing, SEP IRAs and 401Ks have captured the spotlight in recent years, an alternative — the defined benefit plan — should not be overlooked.
Defined benefit plans, or “pension plans,” have been most commonly thought of as a perk for the employees of large corporations or union workers. But many small business owners fail to realize this plan type is an opportune vehicle for creating wealth for themselves and their employees — and reducing their company’s tax burden.
The ABCs of DBPs
Defined benefit plans are a great tool especially for the small business owner who wants to accelerate his or her retirement savings. These plans are typically best suited for owners who are older than their employees and are therefore closer to retirement, and who take home a significant percentage of the company’s annual payroll. Defined benefit plans can be implemented regardless of the number of employees you may have, if any.
The contributions for defined benefit plans are usually calculated from a formula based on the ages of the owner and respective employees and their compensation. The older the employee and the greater their compensation (up to IRS compensation limits), the larger the contribution required for that person.
The amount you can contribute to a defined benefit plan is typically much higher than what can be contributed to a defined contribution plan. A defined contribution plan has lower set limits for allowable contribution amounts. How much lower? A defined benefit plan for a small business owner has the potential to allow contributions that are three to four times higher than what is allowable with a defined contribution plan. Additionally, contribution amounts to defined benefit plans are also adjusted each year to ensure the target goal is reached.
Let’s take a look at a typical example of a small business owner’s annual defined benefit plan investment scenario:
Employees |
Ages |
Annual Contribution |
Annual DB Plan Contribution |
Contribution as % of Total Compensation |
| Owner | 59 |
$220,000 |
$150,000 |
89.8% |
| Employee 1 | 39 |
47,000 |
7,500 |
4.5% |
| Employee 2 | 34 |
42,000 |
4,700 |
2.8% |
| Employee 3 | 29 |
37,000 |
2,900 |
1.7% |
| Employee 4 | 24 |
32,000 |
1,900 |
1.2% |
| Total Contribution | $167,000 |
100.0% |
||
| SUMMARY OF TAX SAVINGS | ||
| Total Contribution for Small Business Owner | $150,000 | |
| Total Contributions & Tax Deduction for the Business | $167,000 | |
| Less: INCOME TAX SAVINGS (Assuming a Federal and State Rate of 45%) |
75,1500 | |
| Net Cash Paid Out | $91,850 | $91,850 |
| Portion Of The Owner's Net Contribution Funded by the TAX SAVINGS | $58,150 | |
In this example your company is aggressively investing in retirement plans by contributing $167,000 to the defined benefit plan of which you, the owner, are getting $150,000 of the money or benefit added to your retirement plan savings. The $167,000 is treated as an expense on your tax return, which can be deducted from revenues. If your business is a Partnership, LLC or S-Corporation which most small businesses are, and you are also in a high tax bracket the tax savings would be along the lines of what the above example shows.
