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The Defined Benefit Pension Plan

Updated: Mar 27, 2023

Defined benefit pension plans can allow big annual deductible contributions if you are approaching middle age or are already there.

Before getting into details, here is an alert: Annual contributions to defined benefit plans are mandatory. Thus, in good times or bad, you have to pay the required annual amount.

The previous articles discussed defined contribution plans where contributions are discretionary, allowing you to contribute little or nothing in years when cash is tight.

Thus, defined benefit plans have two key distinctions:

  1. Required annual contributions

  2. Possible bigger funding of your retirement

Defined Benefit Plan Basics

The defined benefit arrangement promises the plan participant(s) (you and other workers you must cover, if any) a “target” annual retirement check beginning at retirement age. In defining the target, you have the following options:

  • Fixed percentage of income

  • Flat monthly dollar amount

  • Formula based on years of service

The percentage-of-income option is based on an average of self-employment or salary income depending on your business model. You can define the average as income over your entire career or over a certain number of years near the end of your career.

Once you define the retirement income promise, you personally, if you are self-employed, or your corporation, if you are employed by your own C or S corporation, make annual deductible contributions to the plan in amounts sufficient to fund the target retirement payouts.

If self-employed, you claim the deductions on your personal return.

If you operate as a corporation, the corporation claims the deductions on its return.

In what is an added expense for the defined benefit plan, you engage an actuary to compute the required annual contributions based on:

  • the remaining years to retirement,

  • the expected rate of return on investments held in the plan,

  • the promised level of annual benefits, and

  • the plan’s current balance.

Why the Defined Benefit Plan?

The defined benefit plan fits the high earner who is creeping up on retirement age and wants to fund a hefty retirement check of up to $245,000 annually (2022 limit)1.

Advantage 1: Big Deductions (Big Funding)

The high earner age 50 or older finds that the defined benefit pension plan allows larger annual deductible contributions (maybe $100,000 or more) than other retirement plan alternatives.

Advantage 2: Late Funding

You can make the required annual contribution to the defined benefit plan any time up to the due date of the tax return, including extensions, for the year you claim deductions. Thus, sole proprietors can make their 2022 contributions as late as when they file their extension in October 2023.2

Disadvantage 1: Professional Assistance

Unlike plans where you define the contribution and everything is nice and straightforward, you need to spend money on an actuary to define the funding you need in order to produce the defined retirement benefit.

Also, unlike defined contribution plans where you face few tax-law change difficulties, your defined benefit plan often faces tax law changes that require professional assistance and increase your costs.

Much better than before. In years past, costs associated with defined benefit plans often made them ill suited for all but the most well-heeled small businesses. Today, commoditization of small-business defined benefit plans by major brokerages and insurance companies has made defined benefit plans more readily available.

Disadvantage 2: Mandatory Funding

Unlike defined contribution plans, your defined benefit pension plan must be funded. Funding failures trigger an excise tax of 10 percent of the deficiency for each year that the deficiency exists.3 But if the deficiency is not cured by the end of the year, the minimum penalty is increased to 100 percent of the deficiency.4

Disadvantage 3: Covering Employees

If you hire employees then you must consider the employees in the defined benefit pension plan.

The law allows you to exclude from coverage any employees under age 21 and those who have not worked at least 1,000 hours for your business during any 12-month period.5

Your plan design becomes important as you insert employees. The existence of employees does not necessarily destroy your possible benefits from the defined benefit plan, but employees certainly trigger the need for planning.

The Big Picture

You should consider the defined benefit plan if

  • you have a business that generates healthy profits,

  • you are around age 50 or older, and

  • you have and expect to continue to have the cash to make the required contributions.

1IRC Sections 404(a)(1); 404(a)(8); 415(b).; IRC Section 415(b)(1)(A); Notice 2021-61.

2IRC Section 404(a)(6).

3IRC Section 4971(a)(1).

4IRC Section 4971(b)(1).

5IRC Sections 410(a)(1)(A); 410(a)(3)(A).

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