A common trait among successful business owners is their tendency to be solely focused on building their business, typically investing most of their time, energy and money. Therefore, it’s not uncommon for many business owners to reach a late stage in life before establishing any type of retirement plan. Realizing the need to create a retirement income source outside of their business, many will opt for a simple and inexpensive retirement plan option, such as a Simplified Employee Pension (SEP) plan or a SIMPLE IRA. Being easy and inexpensive, these are good plans for getting the ball rolling, but they limit a high earning business owner’s ability to maximize their contributions and the available tax incentives. For a little extra expense, high earning “solopreneurs” may be better served by establishing their own pension plan.
How Does a Defined Benefit Pension Plan Work?
Most business owners are familiar with defined contribution plans, such as a 401(k), SEP IRA or SIMPLE IRA. These plans allow for a certain amount of money to be contributed pre-tax and for the investments to accumulate in a tax-deferred manner. The amount available for income is uncertain, based entirely on the returns earned on investments over the years.
A defined benefit plan works differently in that it can pre-determine the amount of retirement income a business owner receives at retirement based on a percentage of his current income. Contributions to the plan are based on what is needed to provide that pre-determined amount of retirement income. For that reason, it does require actuarial assumptions and computations to figure out the amount of contributions. Generally, the maximum amount of annual contributions that can be made to a defined benefit plan can be 100 percent of the owner’s average earnings for his highest consecutive calendar years up to $215,000 for 2017 (with limits subject to change each year). For older business owners, the annual contribution amount can be even higher if it is needed to fund the retirement income target.
Here is a comparison of contribution levels for the different retirement plan options:
|Maximum Profit Sharing Contribution|
|Maximum Self Employed 401k Contribution w/ Profit Sharing*|
|Maximum SIMPLE IRA Contribution**|
|Maximum SEP IRA Contribution|
|Maximum Defined Benefit Plan Contribution|
Contribution limits for plan year 2017
*Additional $6,000 catch up if 50 or older
**Additional $3,000 catch up if 50 or older
Is a Defined Benefit Plan Right for You?
Defined benefit plans are ideal for high earning solopreneurs who seek to maximize their annual before-tax retirement plan contributions. For solopreneurs, it can be ideal when business income is har-and-above what is needed in an annual salary and bypasses contribution limits of other plans. It can be used in business settings where there are more than more employee, but as it’s a pension plan, all contributions come out of company income.
Defined benefit plans are growing in popularity among high earning solopreneurs of all ages because of the potential for contributing much higher amounts on a tax-favored basis. Their only drawback is they require actuarial-based design and monitoring by a plan administrator to keep them compliant with ERISA laws and to ensure they are on track to meeting the income target. For many business owners, this additional expense is more than offset by the sizable tax benefits realized each year. The other thing to consider is that, once a defined benefit plan is established, contributions must be made every year for a period of 4-6 years; so, it should only be used by businesses with stable and growing revenues.
The good news is business owners have a number of retirement plan options available to them. Choosing the right option – the one that can maximize both your tax benefits and your retirement income -- depends on a number of factors, including your age, tax situation, financial objectives, and your business’s growth potential. Your best move would be to sit down with your financial advisor to explore your options to determine which is the optimal solution for you.