Defined Benefit Plans turn Your Savings into a Pension-Type Retirement
Before defined contribution plans such as 401(k)s became the favorite, defined benefit plans were the preferred retirement savings choice for employers. Recently, however, self-employed, high-income earners helped these plans make a comeback.
What is a Defined Benefit Plan?
Unlike a 401(k), which has a balance dependent on investment performance, a defined benefit plan has a pre-determined benefit that the employer is accountable for paying out. Employers sponsoring these plans will use investments to help reach that defined benefit, but if market performance is poor and the account balance doesn’t grow as projected, the employer is required to make an additional contribution to make up the difference.
The pre-determined amount is dependent on years of service, age, and average salary, and is funded with regular employer contributions. When the employee reaches retirement age, they have the option to receive the benefit either as a lump sum or as regular payments across a set amount of time.
How does a Defined Benefit Plan work for Individuals?
If you’re self-employed, you can sponsor a defined benefit plan for yourself to take advantage of the savings benefits these plans offer.
Compared to other retirement savings vehicles, defined benefit plans have a much higher contribution range. Depending on age and income levels, an individual can contribute up to $61,000 to a SEP IRA or $67,500 to a Solo 401(k), whereas defined benefit plans give self-employed, high-income earners a savings range that can extend well beyond $100,000 depending on a number of different factors. Considering those higher saving limits, these plans offer great opportunities for older individuals who are either just starting to save or would like to add another element to their savings plan and only have a few years left before retirement.
These plans aren’t just for people who are near retirement and need to put away large sums of money in a short period of time. Younger contributors can pair their higher annual savings with compound investment returns, resulting in a significant benefit over the course of a 20- or 30-year career.
The set up and annual administration of a defined benefit plan is more costly compared to traditional tax-deferred savings vehicles. Starting a plan requires working with a firm that specializes in the calculations needed to compute annual contribution ranges and ultimate benefit, but the tax savings achieved during high income earning years is well worth the effort.
What are the Pros & Cons?
There are several pros and cons to weigh before deciding to establish a defined benefit plan. According to the IRS, those factors include:
- Substantial benefits can be provided and accrued within a short time – even with early retirement
- Employers can contribute (and deduct) more than under other retirement plans
- Plan provides a predictable benefit
- Vesting can follow a variety of schedules from immediate to spread out over seven years
- Benefits are not dependent on asset returns
- Plan can be used to promote certain business strategies by offering subsidized early retirement benefits
- Most costly type of plan
- Most administratively complex plan
- An excise tax applies if the minimum contribution requirement is not satisfied
- An excise tax applies if excess contributions are made to the plan