The Ultimate Tax & Retirement Strategy
When business owners first think of retirement plans, they usually consider a 401(k) plan or a SEP. These are greater starter plans. But contributions can be limited for someone looking for large tax deductions. This is when a defined benefit plan could be considered. They offer large contribution limits that very often exceed $300,000 annually.
But before we look at the specifics, let’s first take a look at the two main types of retirement plan structures: defined contribution plans and defined benefit plans.
What’s the Difference?
The ultimate goal of a defined benefit plan is to provide a specific retirement benefit at some point in the future. The annual contributions are made solely by the company. The contribution considers the participant’s salary and age. Upon retirement, the employee can withdraw the money from the plan and pay tax at ordinary tax rates. Alternatively, the funds can be rolled into an IRA.
In contrast, a defined contribution plan (like a 401(k) plan) will specify a maximum annual contribution that can be made by the employee (also called a deferral) and the employer (typically as a profit-sharing contribution). In a defined contribution plan, the account balance at retirement will consist of the cumulative plan contributions in addition to any interest income, dividends and gains or losses.
Tell Me More About Defined Benefit Plans
First of all, the most common type of defined benefit plan structure is called a cash balance plan. Even though it is technically a defined benefit plan, the participant contributions and the employee account balance has the look and feel of a 401(k) plan. The payout is stated as an account balance. As a result, cash balance plans are commonly referred to as a “hybrid” plan. Similar to a 401(k), cash balance plan distributions will be taxed at ordinary tax rates when distributed.
But the nice part is that cash balance plans allow participants to take a lump sum distribution that is equal to the employee’s vested account balance. In addition, a distribution can typically be rolled into an IRA or other company qualified plan.
An important point to note is that these plans work great for owner-only businesses and employers who have fewer than 20 employees. They can be more complex to set up, but in the right situation they can be a home run. Careful planning is critical.
Why do Defined Benefit Plans Work so Well?
Despite knowing the pros and cons of each DBP type, many investors will still struggle to decide which DBP is best for them. Frankly, there’s no right or wrong answer. The key is understanding alignment of interests.
Before investing in any type of private real estate transaction, be sure to understand how the deal is structured. Specifically, look at how much capital the sponsors are putting into the deal. Look for sponsors to have at least 5% to 20% equity to ensure alignment of interests. Then consider the fee structure. How a deal’s waterfall and promotes are structured is critically important to DBPs. Look not only at total fees, but when the fees are incurred. Ideally, you’ll want to see the sponsor (or in some cases, the DBP itself if acting as a third-party intermediary) backloaded. Of course, there will be some fees up front—after all, the sponsor and/or DBP needs to collect some income for running the operation—but most fees should be structured as promotes to ensure the group you’re investing with is incentivized to perform. As an investor, be sure to consider what your preferred rate of return is and over what time horizon, and then what the sponsor is taking as a promote above and beyond that (and when).
Final Thoughts
Consider again the above example. As you can see, there are virtually no retirement plans that allow such large contributions. A 401(k) won’t even come close.
Bottom line, defined benefit plans are excellent options for: (1) small businesses who have consistently large profits; (2) professional service businesses (attorneys, engineers, physicians, etc.); (3) business owners who are behind on retirement and are looking for large “catch-up” contributions; and (4) people in high marginal tax brackets who need the tax deferral.
If you think a defined benefit plan might work for you, make sure you review your situation and funding goals with your financial advisor and accountant. Hopefully, a defined benefit plan becomes an important tool in your retirement planning.
Paul Sundin is a CPA and the President of Emparion, a third-party administrator of defined benefit plans and other tax structures. If you are considering setting up a plan or are looking for a free illustration, please reach out to them here or call him at 1-844-340-1000.