Defined Benefit Plans for Small Businesses and the Self Employed
by Steve Goodman
CPA, MBA – President & Chief Executive Officer
Contact Steve today for more info.
Retirement savings plans fall into one of two classifications: defined benefit (DB) plans or defined contribution (DC) plans. Hybrid plans, such as cash balance plans that contain characteristics of both, are considered defined benefit plans. Pension plans and Social Security are two examples of DB plans. Pension plans were once common among larger employers and governments of all sizes. Most private sector employers have discontinued offering these plans in favor of DC plans.
There are three primary reasons for companies to discontinue DB plans. They include the following:
- Risk – Under a DB plan, the employer/sponsor is responsible for paying the pensioners. The employer assumes legal responsibility for the DB plan’s ability to meet contractual payout needs. If the underlying fund has a shortfall, the pensioners become creditors of the company.
- Variable Annual Contribution – Every year, an actuary must assess the status of the pension fund. Increased annual contributions are correlated with down stock markets, which in turn are correlated with weaker economic conditions. The result is that sponsoring companies need to pay more during weak economic times when some can least afford to pay. Low-interest rates can also result in higher required contributions. The variable and sometimes sizeable nature of annual contributions complicate company financial plans leading many large companies to cancel their pension plans.
- Competition for Employees – As others have discontinued their DB plans, the need for companies to continue their DB plans has diminished.
Among the first to discontinue their plans were the airlines, tire makers, steel companies, and other heavy industries.Many declared bankruptcy in the late 1960s and 1970’s due to weak business conditions and the government’s demand that companies catch up with their underfunded DB plans. The Pension Benefit Guaranty Corporation (PBGC) assumed the pensions from the failed companies. Pensioners found that most received only a portion of their expected benefits. All companies offering DB plans were assessed fees to help make up the shortfall. The increase in fees offered companies one more reason to discontinue their DB plans.
Smaller businesses have identified DB plans as a means of transferring income from a high tax environment to a lower tax environment. IRS regulations permit a maximum annual distribution from a DB plan is $220,000 in 2018. A plan participant can establish a plan with a target payout that is less than the maximum. Those covered under a DB plan may still be eligible to participate in a 401(k) plan.
Small business DB plans are complex programs. IRA’s generally have minimal filing requirements if any. Brokerage and investment firms will often administer the programs at no cost. DB plans require annual filings, set-up filings, and annual actuarial assessments. One should expect to spend a few thousand dollars a year to establish and maintain a DB plan annually. The large investment firms, including Vanguard, Fidelity, Schwab, and many others have departments dedicated to small business DB plans. Small business owners should shop around when establishing a plan.
The optimal small business owner for a DB plan exhibits the following characteristics:
- At least 50 years old.
- Earns at least $250,000 a year
- Has an employee base covered under a collective bargaining agreement? The employer is not required to include these employees in a DB plan.
- Has very few or no employees that might require inclusion in the DB plan.
- Has access to sufficient cash to continue contributions if business turns down
- Has no plans to retire in less than 5 years
- Does not own other affiliated service companies that might require their employees to also be covered by the DB plan.
Owners of multiple businesses looking to establish a DB plan may be required to offer the plan to all qualifying employees at all the businesses. Someone with substantial holdings in multiple businesses should consult an attorney about this concern.
The IRS sets a maximum distribution amount allowed annually. The maximum allowable distribution effectively sets the ceiling on the amount that may be accumulated to define the plan as fully funded. In 2018, the maximum accumulation is approximately $2.8 million. The longer one has to accumulate $2.8 million, the less one must contribute annually. Actuaries re-evaluate the coming year’s contribution annually. One cannot arbitrarily contribute more in a year in which your income is higher.
Those who start a DB plan in their early 40’s are limited in their maximum contributions. They may have 20 to 25 years to contribute until retirement. Those in their mid to late 50’s have much less time to contribute. Their annual contributions must be greater to achieve the same annual distribution. IRS rules permit people younger than their mid to late 50’s to establish a DB plan but with lower annual payouts.
DB plans are designed to replace income in retirement. A couple of facts come into play.
- One cannot deduct more than one earns in any year. If a person makes $125,000/year, it does not make sense to contribute $200,000 annually. The last $75,000 offers no tax deduction and will be taxed when withdrawn.
- One can use a SEP-IRA to deduct a maximum of $55,000 in 2018. Given the significant fees one incurs in administering a DB plan, it makes little financial sense to start a DB plan for annual contributions less than $70,000.
There are two primary reasons for a small business owner to establish a DB plan: tax deductions and retirement savings. One needs an income in the $250,000 range, at a minimum, to justify a DB plan.
Attorneys have developed creative ways to limit the number of employees that must be included in a DP plan. If one has no employees, it is a mute concern. Of possible concern are those who are paid as independent contractors. The IRS defines a person as an employee eligible to participate in a DB plan if he/she meets the following:
- Works at least 1,000 hours per year
- At least 21 years old
- Has at least one year of service
If a labor court finds that the independent contractors should have been treated as employees, the retroactive costs of funding their DB plans can be significant.
An employer has a choice investing options for DB plan participants. The employer can extend the one year of service to two but only by making all company contributions vest immediately. If the company adopts one-year vesting, employees will be 20% vested each year for 5 years, at which time they will be 100% vested.
The fewer people one must include in the program, the more cost-effective the program is for the business owner. Younger employees are much less expensive to include than older people due to the age of constraint.
Access to Cash
One must contribute to a DB plan for five years to receive tax benefits. For people with business incomes that fluctuate annually, the business may not have the cash flow to fund a program in some years. It is possible to modify an existing plan, but it is not a simple or inexpensive change. Expect to pay $7,000 to $10,000 to modify an existing plan. Terminating a plan early can bring significant tax consequences.
Those with sufficient cash reserves to cover short term shortfalls are best suited to accept the responsibility as the plan sponsor. The costs and consequences of falling short in any one year are not worth the trouble, providing the shortfall is a temporary condition.
5 Year Window
IRS regulations require that a company make contributions for a minimum of 5 years to a DB plan. Unlike an IRA, DB contributions are mandatory. Not unlike the challenge faced by corporations who later terminated their plans, mandatory contributions increase following bad market years. The IRS may interpret a failure to complete the 5-year requirement as an early termination of the plan.
In the event of early termination, the IRS may assess the following penalties:
- Employees may be taxed on all benefits when vested rather than when paid out.
- Tax deductions for employer contributions may be deferred.
- The plan may be required to pay taxes on its earnings.
- Plan distributions may be prohibited from tax-free rollover into other retirement accounts.
The IRS identifies many valid reasons to terminate a defined benefit plan before 5 years. These include hardship, bankruptcy, a merger or buyout, health problems affecting the employer and others. The legal costs to file an early termination request can be substantial.
Large company plans typically offer two choices upon the retirement of a plan participant. The retiree can take a lump sum distribution or an annuitized distribution. Not all plans offer the lump sum option, nor are they required to do so. Spouses are the default beneficiary in company plans. A spouse must opt-out to not be listed as the primary beneficiary. It can be beneficial for the spouse to opt-out rather than receive a lower payout due to joint survivor status. In these cases, one may use the excess payout to fund a life insurance policy as compensation.
CPA, MBA – President & Chief Executive Officer
About Steve Goodman
For more than 30 years, Steven has provided insightful solutions to the challenges of business succession, wealth preservation and charitable planning, focusing on the needs of owners of closely held businesses and high net worth individuals.
He's been featured in the New York Times and is an accomplished speaker and has presented over the years to many organizations and professional groups on efficient business succession, estate planning issues and tax strategies. Steven is a CPA who was vice president of the Trust and Investment Division of JP Morgan Chase and a supervisor for KPMG Peat Marwick, and holds an MBA from Fordham University.