Are Defined-Benefit Retirement Plans Better for Small Businesses?

The Pension Protection Act of 2006 has made is possible for many small business owners to pack 20 years of savings into 10. The regulation changing made make the defined benefit hybrid plans legal and very attractive. Although not for every business or professional firm when these plans work it is a win win for the employer and their employees.

President George W. Bush signs into law H.R. 4...
President George W. Bush signs into law H.R. 4, the Pension Protection Act of 2006, Thursday, Aug. 17, 2006. Joining him onstage in the Eisenhower Executive Office Building are, from left: Secretary of Labor Elaine Chao; Rep. Buck McKeon of California; Rep. John Boehner of Ohio; Senator Blanche Lincoln, D-Ark.; Senator Michael Enzi, R-Wyo., and Rep. Bill Thomas of California. (Photo credit: Wikipedia)

Imagine this scenario: Greg is a 55-year-old client who has owned a highly successful marketing firm for 20 years. He has three employees in their 20s and early 30s who make between $20,000 and $35,000 a year, while Greg takes home $200,000 a year. Greg is looking for a retirement plan that will allow the maximum contribution and provide the biggest tax deduction and savings. Greg has not saved as much for retirement as he would like because his focus has been getting his children through college. He is now ready to contribute as much as possible to a retirement plan, as he wants to retire in the next five to 10 years.How would you advise this client?

While small business owners typically use defined-contribution plans with an elective deferral feature to provide retirement benefits to employees, defined-benefit plans may be ideal for small-business owners over 50 who are interested in saving a substantial amount of money for retirement in a short time period.

Defined-benefit plans promise a specific annual retirement benefit based on the percentage of current income the business owner wants to have at retirement, or the percentage of current income he or she can comfortably afford to contribute, up to an annual maximum of $200,000. These plans are best suited for small business owners who are at least 40, earn $100,000 or more a year, plan to contribute more than $50,000 annually to their retirement and have five or fewer employees.

Sponsoring a defined-benefit plan for employees provides them with a determined monthly benefit upon retirement. Defined-benefit plans can be structured to reward employees who stay with the company while minimizing retirement benefits to those employees with short tenures. Participants are not taxed on the retirement benefit until they actually receive a distribution from the defined-benefit plan. An added benefit to the small business owner is that employer contributions provided to a defined-benefit plan are fully deductible as an ordinary business expense.

When considering sponsoring a defined-benefit plan, small business owners must also consider the costs and expenses associated with operating a defined-benefit plan. Such expenses include:

  • Funding the defined-benefit plan
  • Retaining an actuary to determine the amount of the employer contributions
  • Insurance premiums for the defined-benefit plan if the business has more than 26 employees

However, the advantages of defined-benefit plans often outweigh these expenses for small business owners in their late 40s, early 50s or older who meet the following criteria:

  • They want to maximize their annual retirement contribution and are seeking the maximum tax deduction
  • The company has stable cash flow
  • The company has no employees, few employees or a number of employees who are significantly younger than the owner

Small business and professional service firms have more options when saving for retirement than they are aware of. The Pension Protection Act of 2006 makes the hybrid defined benefit plan a great alternative for many business owners.

Please comment or call to discuss how this affect you and you company.

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