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Defined Benefit Plans...Though not as prevalent as they once were, defined benefit pension plans are still popular solutions when deciding on which qualified plan best meets a client's needs. Benefits at retirement are promised to participants by a pre-determined benefit formula based on employee earnings, age, and tenure of service. Annual contributions are tax deductible to the employer. Depending on market performance and assets in the trust, an employers annual contribution obligation may vary and is determined via actuarial calculations.
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Defined Benefit Plans for Cyclical Businesses |
A business came to Benefit Consulting Group with a history of high and low earning years. This could be a real estate broker, a litigator, or someone who had a cyclical business. By providing a benefit level that recognized the business owner's past years of service, the owner was able to make up for those years while the business was building up and while capital was needed for the startup. During the years that high business income was available, the client had a defined benefit formula that produced high contributions, and the business funded tax-deductible contributions up to 50% above its benefit formula, as allowed by IRS funding rules.
When business income went down, the benefit formula was scaled back to reflect the budget needs of the employer, including years when no contribution was made because there were sufficient funds in trust. When plan investments had higher returns, the employer reduced their contribution, and if the assets did not meet the target, the employer made additional payments. A creative plan design with flexibility is one of our strengths here at Benefit Consulting Group. This client's plan is operating in step with the ups and downs inherent to the business's industry sector, thanks in large part to proactive communication. |
A Case for a Defined Benefit Plan over a Profit Sharing Plan |
While enjoying a social occasion, we heard from a successful real estate agent that he was now eligible to start catch-up contributions to his Individual Retirement Account.
Knowing that this put him at 50 years old, we checked with him and found that he would be interested in increasing his tax-deferred contribution. This led to a discussion of defined benefit plans, which have the legal framework to allow a more rapid growth in retirement assets. The agent noted that he was comfortable at a spending level well below his current income(which exceeded $200,000). Based on his age and income, a defined benefit plan could easily cut his taxable income in half, and move the remainder into the pension plan. Further background The real estate industry is one of several where cyclical economic trends can drive a boom or bust business income, including sales agents, mortgage brokers, appraisers and others dependent on property exchanges. Other boom-bust industries include certain types of construction, litigation attorneys, inventors and engineers. Some are able to foresee methods to average out the high and low years of income, so they take action while the times are good to put money aside for the tough times. Pension plans are an effective method for "saving for a rainy day", because they reduce taxes during high income years, provide a reserve fund that grows tax-free, and the plans can be structured to allow little or no contribution during down cycles in the economy. Further, they can be distributed as income in the event of disability or used to provide full or partial retirement. Making better choices But why a defined benefit plan? Two major reasons come to mind. First, the allowable contribution range is much higher. An employer can deduct contributions up to 25% of payroll in a profit sharing plan, but a defined benefit plan is capable of accepting deductible contributions up to the full amount of business income within their much higher limits. The other major reason is that a defined benefit plan can hold trust funds in excess of the benefits payable to employees, and can have deductions for up to a 50% cushion above the benefit levels. To illustrate this, consider a pension plan with liabilities of $1,000,000. So long as the trust fund assets are less than $1,500,000, the employer can take a deduction for the amount to reach that level. Compare that to the lesser of 25% of pay or $53,000 (plus the catch-up of $6,000). The math points to the defined benefit plan as the higher contribution in most cases. |