Defined Benefit Plans and Small Businesses
By Cindy H. Mitchell, CPA, Tax Senior Manager
When most small business owners think about retirement plans for themselves and their employees, they think about 401(k)s, SEP IRAs and profit-sharing plans. These are referred to as defined contribution plans.
However, there may also be a place for a defined benefit plan within a small business. Also known as pension plans, these are usually thought of as benefits for employees of large corporations or unions. But given the right circumstances, they can present a tremendous opportunity for small business owners to build wealth by saving significantly more for retirement than they can with defined contribution plans.
The Best Candidates
Defined benefit plans typically work best for relatively small companies where the owner is older than the employees and receives most of the compensation. They can be especially useful for professional services firms like doctors, dentists and attorneys.
Typically, the firm will set up a pension plan as a supplemental or overlay plan in addition to a defined contribution plan. With this structure, only 40 percent of qualified employees must participate in the pension plan, and they don’t all have to benefit equally from it. There is no minimum number of employees required to set up a pension plan.
Contribution amounts for pension plans are determined based on the ages and compensation amounts of the owner and the participating employees. The older the owner or employee and the greater his or her compensation, the more money must be contributed to the plan.
An example helps illustrate how a pension plan can help a small business owner save large sums of money for retirement each year.
Consider a business with a 60-year-old owner who is paid $200,000 a year and four employees who earn a total of $160,000 a year combined.
To maximize retirement savings, the owner could reduce his compensation to $120,000 and put $80,000 into the pension plan for himself. He could then put another $20,000 in for his employees, to be split equally among them, for a total annual pension plan contribution of $100,000.
But look at the impact of the tax savings: Since the $100,000 contribution is fully deductible, it will result in an income tax savings of $45,000 (assuming a 45 percent combined federal and state tax rate). Therefore, the owner’s net contribution to his own retirement plan (after subtracting the tax savings) is only $35,000. Put another way, the government is funding more than $45,000 of his retirement contribution.
Double-Edged Sword
It’s important to keep in mind that defined benefit plans are not without risk. Unlike defined contribution plans, they guarantee a future benefit amount to each participant, regardless of market performance.
As the financial markets have lost value over the past few years, many pension plans have become underfunded, leaving owners not only with shortfalls in their own retirement savings, but also large financial liabilities to participants.
One possible solution to this problem is to freeze the pension plan. During the time that a plan is frozen, the owner elects not to accrue additional benefits based on the current period activity. Freezing a plan may allow current contributions to be applied against prior liabilities. This helps make up the deficit many plans currently have due to the market downturn of recent years.
The Employee Retirement Income Security Act (ERISA) requires that employees be paid the full amount of their vested pension plan benefit at the time they leave the company. This is a potentially large expense that must be incurred by the business, making freezing the plan an option if employees participating in the plan have left the firm recently, or if the firm has recently had to lay off participating employees. If a relatively low number of employees are participating, and the amounts guaranteed to them are relatively small, this strategy can also enable owners to replenish their own retirement accounts faster.
Freezing a pension plan may be especially attractive in light of what appear to be a rebounding economy and rejuvenated financial markets. But it does require a cash outlay in order to fully fund employees’ accounts, which a business may not be able to afford.