A Defined Benefit Plan Lets You Sock Away Large Amounts If You Can Overcome Some Obstacles
Is your 401(k) not enough? With a Defined Benefit (DB) plan, you can sock away around $2 million for retirement over a relatively short period of time while deferring taxation. Plus, you can still contribute to a 401(k), SEP, or other personal retirement account. If you’ve gotten a late start on retirement saving, a DB plan could help you quickly catch up. But it won’t have much effect unless you can afford to fund it generously—for yourself and your employees.
Unlike a Defined Contribution plan, such as a 401(k), which is built around what goes into it, a DB plan is based on what comes out during retirement. A fully funded plan could guarantee that you’ll receive as much as $2 million, either in a lump sum or as annuitized payments. To make sure you get there, actuarial calculations determine how much you must contribute each year. The size of that annual contribution is influenced by many factors, including the number of employees participating, their age and salary, and performance of the plan’s investments. In good years for the market, your contribution may be smaller, while a weak market could require you to write a larger check.
A DB plan lets you receive an annual benefit equal to 100% of your company salary, up to $180,000 a year, until your benefit reaches the $2 million limit. With no limit on the annual contribution, a DB plan can be the ultimate catch-up tool for retirement for a small business owner with few employees and who is nearing retirement. Assuming you have the cash to make the maximum contributions allowed, you could accumulate $2 million in as little as a decade, depending on the return on plan investments. Meanwhile, you can continue to fund your own Defined Contribution plan, deferring taxation on another $45,000 in income each year.
The chief drawback to a DB plan is that if you have employees, you’ll have to fund their retirement benefit, too. That may not be a huge burden if your workers are mostly young and earning low salaries. But if you’re paying into the plan for well-paid employees nearing retirement age, the total contribution required could amount to a substantial drain. In general, any employee who is at least 21 and has worked for the company for a year or more must be covered by your plan.
Of course, making contributions for employees won’t be an issue if yours is a one-person business. In fact, even those without a corporate structure may establish a DB plan.
DB plans offer estate planning advantages. If your plan is set up to continue payments to a surviving spouse after your death, the ongoing income won’t be taxed as part of your estate, though your spouse will pay income tax on the payouts. In contrast, an inherited IRA or 401(k) could be subject to estate tax.
This article was written by a professional financial journalist for Legend Financial Advisors, Inc.® and is not intended as legal or investment advice.