For Big Tax-Deductible Contributions, Consider a Defined Benefit Plan

By David J. Kupstas, FSA, EA, MSEA

David J. Kupstas, FSA, EA, MSEA

David J. Kupstas, FSA, EA, MSEA Chief Actuary

Small business owners who are looking for tax-deductible retirement contributions greater than those available in a 401(k) plan should consider adopting a defined benefit (DB) plan. 

When we say “big” tax-deductible contributions, just how much are we talking about?  It depends on various factors such as age, compensation, years of service, and years of plan participation.  We recently met with a 60-year-old and determined he could fund $200,000 per year easily for just himself.  A 65-year-old we work with can contribute $300,000 or $400,000 for himself but is limiting himself to “only” $240,000.  Yet another client in his late 40s is able to contribute $150,000.  By contrast, in a 401(k) plan an individual is able to make or receive contributions of only $54,000 ($60,000 if age 50 or older). 

A Big-Company Concept for Small Businesses 

Many people do not know about the contribution opportunities available in DB plans.  DB plans have been around for decades, even centuries.  These are the traditional pension plans that cover workers at factories, airlines, schools, and governments.  DB plans for small businesses operate pretty much under the same rules. 

Small business owners are allowed to set up DB plans designed to replace in retirement some percentage of the income they received while working.  The income to be replaced may not exceed 100% of what they earned in the highest three consecutive years.  There is also a dollar limit on the income replacement that varies by age and number of years in the plan.  For someone age 62 through 65 with at least 10 years of plan participation, the annual dollar limit for income replacement is $215,000. 

In a small plan, very few people actually end up with monthly retirement income.  Rather, small plan participants almost always elect a single lump sum payment that is the actuarial present value of the monthly income the plan is designed to replace.  A 62-year-old with at least 10 years of plan participation and high enough compensation could walk away with a DB lump sum of $2.7 million.  Others at different ages, income levels, and plan longevity would have different limits.  The lump sum may be rolled to an IRA to continue the deferral on taxes. 

Maximum DB Contributions Not Found on Table or Chart 

When a DB plan participant retires, enough money needs to be in the plan so that the pension can be started or lump sum paid.  The plan sponsor cannot just deposit the money all at once when it is time to make payouts.  DB plans do not operate on a pay-as-you-go basis.  Instead, contributions must be made systematically over a period of years.  The law dictates a minimum required contribution and a maximum deductible contribution each year. 

You cannot look on a table or news release anywhere and find the maximum DB contribution in a given year for a given participant.  Instead, the minimum and maximum contributions have to be computed or certified by an enrolled actuary authorized to practice before the IRS.  The plan sponsor chooses a contribution amount that is within the permissible range, often with guidance from the actuary. 

As an example, the actuary may determine that the minimum contribution for the plan is $100,000 and the maximum deductible contribution is $400,000.  The plan sponsor could choose to contribute any amount within this range.  The actuary may point out that any contribution in excess of $200,000, although immediately deductible, may lead to negative consequences down the road in terms of overfunding.  An excellent outcome is when the minimum contribution is $0 and the maximum contribution is some high amount like $200,000.  In that case, the DB plan has almost as much flexibility as a defined contribution plan for that particular year in terms of being able to choose a contribution amount. 

If the numbers being tossed around in this article are too high for a business owner to consider, a plan calling for lower contributions may be designed.  However, if the desired individual contribution level is $60,000 per year or less, the 401(k) plan is the better option. 

Who Should Adopt a DB Plan? 

DB plans may be sponsored by all types of business entities – C corporations, S corporations, LLCs, partnerships, sole proprietorships, and others.  Corporations will need to be sure there is enough money left in the business to make the required or desired contribution after all other expenses are paid, including salaries and bonuses.  For self-employed individuals, the self-employment earnings number has to be big enough to cover the plan contribution as well as the earned income on which the plan benefits are based. 

For small businesses, traditional DBs work extremely well when there are no other employees besides the owner and his/her spouse.  If there are employees who will be covered by a plan, we normally recommend a cash balance plan paired with a 401(k).  Cash balance plans are a special kind of DB plan. 

ACG has decades of experience designing DB plans to help small business owners save on taxes.  We would enjoy the opportunity to help you do the same.

— Topics: Retirement, Tax Strategy, Financial Planning