Would you like to take a six-figure tax deduction every year and be able to keep the money? 

If so, let’s talk about defined benefit plans (DBPs) for business owners. For some savvy business owners, defined benefit plans offer huge retirement benefits and massive tax savings.

So why set up a defined benefit plan? Read on to find out.

What is a defined benefit plan?

A defined benefit plan—also known as a pension—is an employer-sponsored retirement plan guaranteeing a fixed benefit at retirement. That benefit is based on a formula that considers salary history and employment duration. 

Unlike 401(k)s, which define contributions but not benefits, DBPs provide a predictable retirement income.

I know you’re thinking, “Haven’t pensions disappeared?” Yes, for big companies with a lot of employees, pensions often don’t make financial sense. But for the right business owner, they’re transformative.

Who’s a defined benefit plan for?

Defined benefit plans are ideal for self-employed people with no employees or for those with only a few younger employees. 

Why? 

Employees don’t contribute to defined benefit plans—only the employer contributes. Since required annual contributions are based partly on participants’ age, business owners can funnel more contributions to their own retirement accounts. 

So, if you already max out your retirement contributions and have a small staff, DBPs allow much larger contributions than a 401(k) or Simplified Employee Pension (SEP) IRA.

This makes them a pretty appealing option for successful business owners who want to turbo-charge their retirement savings for the future while slashing their tax bills today.

How does it work?

With a DBP, employers contribute to the plan to meet future promised benefits. These contributions are tax-deductible for the employer, reducing taxable income. The benefit is determined using a formula that considers the participant’s earnings history, tenure, and age.

A quick look at DBP rules and requirements

• Funding. Employers fund the plan, and they usually require hefty annual contributions—especially for older participants nearing retirement—because the plan balance needs to grow large enough to provide the promised benefit by the time the participant hits retirement age. Contributions can hit six figures annually if the owner is in their 50s. Plus, the business has to make contributions every year, regardless of whether they turned a profit.
• Benefit calculation. An actuary calculates the benefits annually based on years of service and the average salary.
• Contribution limits. The annual benefit for a DBP participant cannot exceed the lesser of:
  • 100% of the participant’s average compensation for their highest consecutive calendar years or
  • $275,000 for 2024. (That dollar limit is subject to annual cost-of-living adjustments).
• Fiduciary responsibilities. DBPs must comply with strict regulations, including Employee Retirement Income Security Act (ERISA) funding rules. Employers also have to file Form 5500 with the Internal Revenue Service (IRS) and the Department of Labor (DOL) each year to provide information about the plan assets, qualifications, participants, and operations.
• Security. The Pension Benefit Guaranty Corporation (PBGC) insures most DBPs, giving participants an extra layer of security.
• Costs. Ideally, the business owner can contribute anywhere from $100,000 to $150,000 annually for at least ten years. The plan also has administrative costs, including startup fees, annual actuarial calculations, and filing fees for Form 5500. But since all contributions are tax-deferred, the tax savings often outweigh the plan fees.
• Potential tax credit. Businesses might be able to claim the Retirement Plans Startup Costs Tax Credit for the first three years of the DBP. However, to claim this credit, you must have at least one employee who doesn’t fall under the category of highly compensated employees.
• Withdrawals. Earnings grow on a tax-deferred basis and are taxable when withdrawn at retirement. As with most qualified retirement plans, early withdrawals are subject to penalties.
• Maximize retirement benefits. Contributing to a DBP doesn’t stop you from adding money to other retirement plans like a Solo 401(k) or SEP IRA to maximize your retirement savings.
• Protection from creditors. DBP assets are shielded from creditors, protecting your retirement savings even if your business faces lawsuits.

Alternatives to defined benefit plans

If a DBP seems too demanding, consider:

• Defined contribution plans like a 401(k) or 403(b)
• Employee stock ownership plan (ESOP)
• Profit sharing plans
• SEP IRA

You might also consider a cash balance plan. Cash balance plans are essentially hybrids of defined benefit plans and defined contribution plans where benefits are stated in terms of each employee’s account balance.

For example, if a participant’s cash balance in the plan is $200,000 when they reach normal retirement age, they have a right to an annuity based on that amount. They could also choose a lump sum payment and roll it into an IRA or another employer-sponsored retirement account.

Is a defined benefit plan a viable option for your retirement savings?

While DBPs are complex, they offer successful business owners a reliable way to pave the way for a secure retirement while slashing taxable income.

If you’ve maxed out your annual contribution limits, have no employees, or just a few much younger employees, let’s chat about whether a DBP is your golden ticket. We can explore your retirement plan options and the potential to use a DBP as a tax-saving tool.