To Be, Or Not to Be, Using a Defined Benefit Plan: Part I
The conversation surrounding defined benefit plans can go one of two ways. On the one hand, the changing retirement landscape has shown many individuals are not good at saving for retirement on their own. Those individuals long for the days when they were provided a secure retirement by their employer through a traditional defined benefit plan.
On the other hand, many of us have seen the negative headlines about the underfunding of these plans, and some employers can’t wait to get out of them. In the first of a two part series, we focus on the positive side: when defined benefit plans can have a great impact on your retirement.
In order to retire comfortably, a general rule of thumb states you should have eight times your salary saved. For many executives and entrepreneurs who earn large sums of money, it can be difficult to put away sufficient funds in a 401(k) plan or defined contribution plan because of the IRS limits on total compensation and maximum contributions allowed. Combining these limitations with increased taxes on high income earners creates a big savings gap. One way to help bridge the gap is through a defined benefit plan.
What is a defined benefit plan?
Although defined benefit plans are not new to the retirement landscape, the way businesses are using them has changed. A defined benefit plan is any plan that “defines” a benefit, either a lump sum or more typically, a monthly distribution, to be received at or after the traditional retirement age.
For younger employees, it can be difficult to see the value in traditional defined benefit plans, particularly in an environment where employees rarely stay with one company for their entire career. In traditional defined benefit plans, the employer bears all of the risk and creates an ongoing liability. However, creative new designs can help many entrepreneurs, employers, and executives turn these plans into great assets that are worth the liability.
With new, non-traditional defined benefit plans, such as a cash balance plan, the look and feel is similar to a 401(k) plan. Employees can access their account balance and gain a better understanding of its value, and employers have more certainty in the annual funding of the plan as it is based off of interest rates, such as the 30 year treasury or a fixed rate of 4%. This helps reduce many of the stresses employers faced with traditional defined benefit plans.
For high income earners, defined benefit plans can provide a great way to reduce tax liability. With income taxes at 40% on earnings above $450,000 for married couples or $400,000 for individuals – not to mention investment and capital gains taxes – many high income earners are searching for creative ways to reduce their tax burden. Depending on income, implementing a defined benefit plan may be a valuable solution. By putting more savings into a defined benefit plan than is allowed in 401(k) and other defined contribution plans, you have the ability to reduce your compensation to a more tax-friendly level.
For owners who are closer to retirement age, the allowable deferral can be between $200,000 and $300,000, which is substantial. This gives executives more opportunity to save at a faster rate than in 401(k) plans. Defined benefit plans need to be carefully designed, and working with a trusted advisor can help maximize benefits for your key employees while meeting the legal requirements of a defined benefit plan. To set up a plan, you need to work with an actuary and also fulfill yearly filing requirements. Moreover, the plan must be viable for at least 3 to 5 years. There are limits on what you can contribute, but the plan design is flexible and can be tailored specifically to your business.
Who is usually a good fit for a cash balance defined benefit plan?
These plans often are a good fit for professional firms, such as medical, law, and accounting practices, where there are key employees and owners that the firm clearly wants to benefit and incentivize. Cash balance plans offer a flexible solution to achieve those goals.
It is also a great vehicle for employers who are already maximizing contributions to a 401(k) or profit sharing plan and have the means and desire to save more. It can be a useful tool for owners/key employees who have fallen behind on their retirement savings from the 2008 recession or have not saved enough in the earlier stages of their careers.
For high-earning sole proprietors, defined benefit plans can provide a balance of retirement savings and tax liability management.
If you or a colleague has a need for a defined benefit plan or is interested in learning more, please contact our Director of Retirement Services, Paula Hendrickson, at firstname.lastname@example.org.
Be on the lookout for the second part of our series, focusing on exit strategies for large companies who have decided to terminate or freeze their defined benefit plans and are looking for a way to effectively transition to a different benefits solution.
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First Western Trust cannot provide tax advice. Please consult your tax advisor for guidance on how the information contained within may apply to your specific situation.