There are a number of retirement plan options available to small business owners. Yet for older higher income business owners, the best option might be the least used option – defined benefit pension plans.
Defined benefit plans are often referred to as pension plans, because they provide a guaranteed retirement benefit and they must be funded by employers each year. This is just the opposite of defined contribution plans, which provide a retirement benefit equal to the plan savings and, most of which, do not have to be funded by employers. The 401(k) and IRA are the most common defined contribution plans.
So why are defined benefit plans better than defined contribution plans? The answer is that the defined benefit plan can allow older business owners (i.e., 45+ years old) contribute significantly more to their retirement plan each year and they allow the employer to get a federal income tax deduction for the full amount of this larger contribution.
For example, the SEP IRA currently allows business owners to sock away $44,000 each year. This amount then grows tax free until the owner starts taking retirement distributions. Compare that to the $175,000 maximum annual target benefit that can be funded for a defined benefit plan.
In the past the costs for administering defined benefit plans placed them out of the reach of most small business owners. However, a number of custodians have recently started offering these plans at a modest cost (with some custodians charging ~$5,000 per year to administer the plan).
These plans do require a little more paperwork. Specifically, the owner must have annual actuarial calculations performed and the owner must ensure that the plan files an annual tax return (the Form 5500).
Here are a couple of caveats about defined benefit plans:
- The defined benefit plan must be funded by the employer each year; therefore, these plans should only be considered by business owners who are willing to make continued payments into the plan each year.
- The defined benefit plan must be made available to certain employees; therefore, business owners who employ many employees may need to carefully design the plan to exclude all but the intended recipients.
You can find out more about defined benefit plans by talking with your financial advisor, attorney or contacting a custodian directly.