If you are self-employed, you might be surprised at some of the options you have when it comes to saving for retirement.
It’s possible to use an individual 401(k) or a SEP IRA to boost your retirement savings. But what if the fairly generous terms for these retirement accounts still aren’t enough for you?
What is a Defined Benefit Plan?
Qualified retirement plans are divided into two main types. A defined contribution plan is one that focuses on what you put into the account. IRAs and 401(k)s are examples of defined contribution plans. The defined benefit plan, on the other hand, focuses on what you receive during retirement. A pension is a good example of a defined benefit plan.
Defined benefit plans have mostly disappeared from our business lexicon, but that doesn’t mean that they don’t exist. For many entrepreneurs with very small businesses (think one or two people), the defined benefit plan can be a great way to turbo-charge your retirement savings, and reduce your current taxes in the process.
How the Defined Benefit Plan Works to Your Advantage
When you set up your defined benefit plan, you specify how much the retirement payout will be, based on age and years working for the company. In order to meet the payout specifications, you have to fund the plan at a certain level. That means that it’s possible for you, depending on a number of factors, to contribute up to $205,000 for 2013 — for your retirement. Combined with a solo 401(k) or SEP IRA it’s possible you can put up to $256,000 per year for retirement.
If you are self-employed, and have grown your business to the point where you can afford to put tens of thousands of dollars a year into a retirement plan, setting up a defined benefit plan can be a smart move. You can easily build your nest egg to $1 million in 10 years when you’re putting $100,000 away each year.
On top of that, you can reduce your current tax liability. The defined benefit plan contributions reduce your business income, and that in turn can reduce your personal income (since your business income flows to your personal income). You can decrease your tax rate, deferring to a later date, allowing your money to grow more efficiently right now.
Things You Should Know about Defined Benefit Plans
Before you get too excited about setting up a defined benefit plan for your business, there are a few things you should know:
- Minimum Level Funding: Once you set up your defined benefit plan, you have to fund the minimum level each year to meet the pay out requirements. If you run into cash flow problems, you still have to fund your plan. Make sure you can handle the minimums at the payout level you want.
- Payout Limits: Since your benefit is defined, you are limited when it comes to withdrawing from the account. You can only withdraw a set amount per year during your retirement. To get around this, you may have to roll the money from the plan into a more conventional retirement account.
- It Can Get Pricey: If you have a lot of employees, a defined benefit plan gets expensive fast. If you set up a defined benefit plan to help your retirement savings, you have to contribute to the plan for all of your employees as well. Carefully think about your business, and whether you plan to scale up. The best candidates are those who have no more than one or two employees beyond themselves.
- Actuarial Calculations: When you offer a defined benefit plan, you have to hire an actuary to perform the calculations that determine minimum funding levels for each employee. This must be done every year.
Even with some of the costs associated with a defined benefit plan, it can be a great choice for the self-employed businessperson who wants to dramatically ramp up retirement account contributions.