Now You Know

Defined Contribution Plans Versus Defined Benefit Plans

Have you procrastinated in setting up a tax-advantaged retirement plan for your business? If the answer is yes, you’re not alone. Still, not having a plan in place hurts you and your business. Why? You’re paying more income taxes every year than necessary — money that could be used for better purposes.

However, you still have time to set things right and line yourself up for major tax savings for this year and beyond. This article explains the basics of tax-advantaged retirement plans, which are now better than ever thanks to changes in the tax law that permit larger annual deductible contributions. Once you cut through all the technical details, you’ll discover that tax-advantaged retirement plans come in two basic varieties:

  1. Defined contribution plans (which, as you will see, come in several varieties themselves).
  2. Defined benefit pension plans (which only come in one variety).

Defined Contribution Plans

With these plans, annual deductible contributions are made to your account. The maximum annual contribution amount is specified by the tax law (usually with annual inflation adjustments). For small businesses, contributions are generally discretionary, which means you don’t need to contribute anything in years when cash is tight.
Your account balance at retirement age will depend on:

  • How soon you begin contributing.
  • How much you contribute.
  • The rate of return earned on investments held in your account.

The sooner you start contributing, the sooner you’ll start reaping annual tax savings. Your account’s earnings are allowed to accumulate tax-free until you begin taking withdrawals. Even better, there’s no limit on how much can be accumulated in your account. Defined contribution plans include defined contribution Keogh plans, corporate profit-sharing plans, and simplified employee pensions (SEPs).

Some defined contribution plans allow so-called salary reduction or elective deferral contributions, which come out of your salary (or are deemed to come from your salary if you are self-employed). These plans also allow additional contributions to be made by your employer (or deemed to be made by the employer if you are self-employed). Salary reduction arrangements include 401(k) plans and SIMPLE plans. In any case, the distinguishing feature of a defined contribution plan is the maximum amount that can be contributed to your account each year.

It is calculated based on a percentage of your compensation or self-employment income for that year — subject to an annual maximum contribution limit which for 2019 is:

  • $56,000 — or $62,000 for a 401(k) plan if you are 50 or older as of 12/31/19 (up from $55,000 and $61,000 respectively in 2018).
  • $13,000 for a SIMPLE plan (up from $12,500 in 2018).

Defined Benefit Plans

With this plan, contributions to your account are based on what is needed to fund a promised “target” level of annual payments after you reach retirement age. The annual benefit is usually based on a percentage of earnings during your last few years of work. You (if you’re self-employed) or your company (if employed by your own corporation) make annual deductible contributions to your account in amounts sufficient to fund the promised level of retirement-age payouts.

Contribution amounts must be calculated by an actuary based on:

  • Your remaining number of years to retirement.
  • The expected rate of return on investments held in your account.
  • The promised level of annual benefits.
  • Your current account balance.

Here’s the key selling point: Very large annual contributions are required to adequately fund your defined benefit account if you are a high earner and relatively close to retirement age. In this scenario, you have only a few years left to build up an account balance big enough to deliver the promised hefty level of annual post-retirement payouts. Large annual contributions translate into large annual deductions, which in turn translate into large annual tax savings for you.

For 2019, a defined benefit plan cannot specify a target annual payout in excess of $225,000 (up from $220,000 in 2018). This limit is adjusted annually for inflation. If you run your business as a sole proprietorship or single-member LLC, a defined benefit arrangement takes the form of a Keogh defined benefit pension plan. If you’re employed by your own S or C corporation, the company establishes a corporate defined benefit pension plan on your behalf. For high earners, age 50 or over, with plenty of available cash, the defined benefit pension plan may be the best choice. However, a defined benefit arrangement is generally more expensive to establish and operate than other alternatives.

Another negative: You’re locked into mandatory annual contributions until your account becomes fully funded. For these reasons, you should strongly consider the 401(k) plan option, which also permits larger annual deductible contributions for those age 50 and older. Now you see the basics of defined contribution plans and defined benefit pension plans and how they can help fund your retirement. Contact your benefits adviser if you have questions or want more information about the best plan in your situation.

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