Defined Benefit Plans for Small Business Owners
As a small business owner, you face the crucial task of planning for your financial future and that of your team. Have you considered the defined benefit plan? This retirement option promises a set retirement income and is gaining relevance for businesses like yours.
Although many perceive this as a tool for larger companies, it offers significant opportunities for businesses of your scale. This guide will help you navigate its complexities, empowering you to make well-informed retirement planning decisions.
Table of Contents
- What is a Defined Benefit Plan?
- The Two Main Types of Defined Benefit Plans
- Defined Contribution Plan vs Defined Benefit Plan
- Pros and Cons of Defined Benefit Plans for Small Business Owners
- How to Set Up Defined Benefit Plans for Small Business Owners
- Defined Benefit Plans for Small Business Owners FAQs
- How We Help With Defined Benefit Plans for Small Business Owners
What is a Defined Benefit Plan?
When you think about retirement planning, it’s natural to focus on savings, investments, and future security. A crucial aspect is understanding the different retirement plan structures available. The defined benefit plan, sometimes called a defined benefit pension plan, promises a specified monthly benefit when you retire. It may seem simple, but there’s more beneath the surface.
Unlike other retirement plans where benefits depend on investment returns, in a defined benefit plan, your retirement income is predetermined. Typically, it’s based on factors like how long you or your employee has been with your business, and earnings, especially in the years leading up to retirement.
The Two Main Types of Defined Benefit Plans
Below, are the two main types of defined benefit plans:
1. Traditional Pension Plan
This is probably what comes to mind first. It offers retirement benefits based mostly on an employee’s final salary and years of service. Generally, the longer someone is with your company and the higher their salary, the larger the pension.
2. Cash Balance Plans
These are newer and blend features of both a defined benefit and defined contribution plan. Here, each employee has an account, credited with a percentage of their annual compensation plus interest. At retirement, they receive this accumulated balance, guaranteed by you, the employer.
Defined Contribution Plan vs Defined Benefit Plan
Defined contribution plans and defined benefit plans can both be used as vehicles for retirement. However, it’s important to distinguish between these two types of retirement because they represent fundamentally different approaches to retirement savings.
With defined contribution plans (e.g. 401k plans or SEP IRAs), both the employer and employee contribute to the employee’s individual retirement account. The final retirement balance and income are contingent on the contributions made and the investment returns achieved. There’s no guarantee of a specific retirement income.
On the other hand, a defined benefit plan promises a specific amount of retirement income. This guarantee offers peace of mind to employees, but it also means the employer bears the investment risk. If the investments underperform, it’s up to the employer to make up the shortfall.
Pros and Cons of Defined Benefit Plans for Small Business Owners
Defined benefit plans bring unique advantages for business owners like you aiming to secure financial futures. But, they also have challenges. Let’s explore the pros and cons to help you decide if it’s right for your business.
Advantages of defined benefit plans for small business owners:
Higher Contribution Amounts: This is a significant perk, especially for high-income earners or those nearing retirement age. Defined benefit plans often allow for larger tax-deductible contributions compared to many defined contribution plans, making them an attractive option for maximizing retirement savings and reducing current taxable income.
Guaranteed Retirement Income: In today’s uncertain financial landscape, the promise of a fixed, predictable retirement income can be a considerable relief.
Employer Control: For small business owners who like to have control over their business operations, this plan type offers the advantage of controlling the plan’s investments.
Attract and Retain Talent: In a competitive job market, having a robust defined benefit plan can act as a magnet for top talent. It’s a clear signal that a business is invested in the long-term well-being of its employees.
Disadvantages of defined benefit plans for small business owners:
Required Annual Contributions: While a profit-sharing plan or SEP IRA might offer flexibility in contributions, defined benefit plans typically have mandatory annual contributions. This can strain cash flows, especially in lean years.
Complex Setup and Maintenance: A significant hurdle for many small business owners. Setting up a defined benefit plan requires navigating intricate regulations and often necessitates the expertise of a professional like a financial advisor.
Higher Administration Costs: Beyond setup, these plans require ongoing management. Annual evaluations, IRS filings, and other administrative tasks can add up in terms of both time and money.
How to Set Up Defined Benefit Plans for Small Business Owners
Considering a defined benefit plan for your small business? Here’s a structured approach to help you set up one efficiently and effectively:
Step 1) Assess Your Business Needs: Begin by understanding why you’re setting up the plan. Are you primarily looking for a tax shelter, building a competitive employee benefits package, or preparing for your own retirement?
Step 2) Consult Professionals: Given the complexity, engaging with a financial advisor or other qualified professional early in the process can save headaches down the line.
Step 3 ) Draft a Plan Document: This foundational document will outline the terms of the plan, defining benefits, eligibility criteria, and operational procedures.
Step 4) Determine Funding Strategy: Decide how much needs to be contributed each year, factoring in variables like employee salaries, tenure, and the required annual contributions.
Step 5) Implement the Plan: Once your plan is crafted, it’s time to roll it out. This involves not only setting up the financial infrastructure but also educating employees about the plan’s benefits and operations.
Defined Benefit Plans for Small Business Owners FAQs
1. What Happens When a Defined Benefit Plan is Terminated?
When a defined benefit plan comes to an end, it’s essential to understand the implications for both employers and employees. One crucial thing to remember is that employees’ earned benefits up to the termination point are locked in and can’t be taken away.
After the plan ends, there are options for how these funds are used. One common approach is to get annuities, which will provide regular income payments over time. Another choice for employees is to move the money into a different retirement account, like an IRA, allowing them to continue planning and saving for their retirement.
2. Can A Self-Employed Person Have A Defined Benefit Plan?
Yes, self-employed people can definitely set up and benefit from defined benefit plans. In fact, if you’re a high-earning self-employed individual, this type of plan can be especially beneficial. It lets you save a significant amount for retirement in a shorter period. Plus, there’s a bonus: the money you put into the plan can often be deducted from your taxes, which can lead to some significant tax savings.
Please Note: For a comprehensive understanding of how defined benefit plans work with self-employed individuals, check out our detailed article on the topic.
3. How Does Defined Benefit Plan Administration Work?
Managing a defined benefit plan is more complex than handling other retirement plans, like 401(k)s. A major part of this process involves yearly calculations by experts called actuaries. They figure out how much money needs to be in the plan to cover the retirement benefits promised to employees.
These experts look at what the plan owns, what it owes, and the benefits it’s committed to providing to make sure everything stays on track. On top of this, regular check-ins and paperwork with the IRS are required to ensure everything is up-to-code and transparent.
Please Note: Our firm excels at alleviating administrative burdens for our small business owner clients. Through collaboration with our third-party administrator partners, we help handle the administrative aspects of your defined benefit plan seamlessly. If you require assistance, please schedule a call with our team.
4. What are the Defined Benefit Contribution Limits?
While other retirement plans might have straightforward dollar limits on how much you can put in each year, defined benefit plans are a bit different. Instead of a set dollar amount limit, these plans focus on the actual retirement benefits or income you’re aiming for.
Expert actuaries come in to figure out how much needs to be contributed to reach that goal. They look at things like the retirement income you want, your current age, when you plan to retire, and how much return you might get on the plan’s investments. In simpler terms, the contributions are designed specifically around your retirement needs and goals.
How We Help With Defined Benefit Plans for Small Business Owners
At Fischer Investment Strategies, we recognize the challenges and opportunities faced by small business owners in navigating the retirement planning landscape. Defined benefit plans can be an incredibly potent tool, offering both tax advantages and the promise of secure retirement income. Yet, understanding and managing such a plan requires a level of expertise that many business owners might not possess internally.
Beyond mere setup, the ongoing management of these plans is a task in and of itself. Regular actuarial calculations, IRS filings, and administrative tasks can be time-consuming and confusing. Our seasoned professionals are equipped to alleviate these burdens, allowing you to focus on what you do best—running your business
Whether you’re a high-earning self-employed individual or a small business owner with numerous employees, we cater our solutions to fit your specific scenario. We invite you to leverage our firm’s expertise, ensuring that you and your employees have a secure financial future ahead.
Don’t navigate these waters alone! You can call us directly at our Westlake office at (805) 418-7686, or our San Clemente office at (949) 433-7768. Feel free to also schedule a complimentary consultation at a time that works best for you.
Ted Fischer is a Fee-Only Certified Financial Planner® & fiduciary, and the founder of Fischer Investment Strategies.
Drawing from more than 25 years of experience in the financial services industry, Ted's expertise includes retirement planning, investment analysis, tax planning, estate planning, and insurance.
Ted has an extensive academic background. He received his Certified Financial Planning (CFP®) designation from UCLA in 2011. He became a Qualified Plan Financial Consultant (QPFC®) and an Accredited Investment Fiduciary (AIF®). Ted has a Bachelor of Science in Marketing, with a minor in Finance, from San Diego State University.