When it comes to setting up a retirement plan, small business owners have various options to choose from. Understanding the various options can be challenging, however it’s important for small business owners to carefully consider which retirement plan is the best fit for them and their situation. While it is best practice to consult your financial advisor and tax professionals throughout the process, some key considerations include the number of employees in the business, the plan’s maximum annual contribution limits, and the plan’s ease of administration.
There are two main types of retirement plans: defined contribution or IRA-based plans and defined benefit plans. This article will focus on defined benefit plans.
Generally speaking, defined benefit plans are tax-deferred retirement plans that are sponsored by the employer. With defined benefit plans, retirement benefits are guaranteed by the employer and can be received as either a lump sum or annuity. The benefit in retirement is calculated based on a formula that considers several factors, such as length of employment and salary history.
In contrast, a defined contribution (or IRA-based) plan provides retirement benefits that are not guaranteed by the employer and are determined by the investment performance in the account. As the business owner, it’s important to remember that you act as both an employee and the employer for whichever retirement plan you participate in.
Regardless of which type of plan is chosen there are two main options for defined benefit plans: traditional defined benefit plans and cash balance plans.
Traditional defined benefit plans are typically well-suited for small business owners who have no employees and a high income level. The amount of allowable annual contributions to a defined benefit plan are based on “what is needed to provide definitely determinable benefits to plan participants” (per the IRS website).
Each year, an actuary is required to calculate this funding range, which includes both a required minimum amount and an allowable maximum amount. The maximum annual benefit for a defined benefit plan participant in 2021 is $230,000, which could also limit the maximum annual contribution amount. For example. a business owner who is 50 years old and earns at least $290,000 in 2021, this could potentially equate to a maximum annual contribution limit of up to $219,000. Since an actuary is required to do these calculations each year, these plans have high setup and annual fees. The employer is also required to file an annual report to the IRS. Lastly, traditional defined benefit plans define the guaranteed benefit as a series of monthly payments that typically start at retirement and continue for life.
Overall, traditional defined benefit plans can be attractive to small business owners who want to save significant amounts of money each year, which can be especially beneficial to those close to retirement, but are also willing to accept minimum funding requirements, higher annual fees, and annual administrative requirements.
Cash balance plans are also typically well-suited for small business owners who have no employees and a high income level. They are very similar to traditional defined benefit plans, however the main difference is how the guaranteed retirement benefits are calculated. While both types of plans have the option to receive benefits as a lump sum or annuity, lump sum calculations for cash balance plans are not sensitive to interest rates.
Also, Cash balance plans define the guaranteed benefit as a stated account balance. These stated account balances, also referred to as hypothetical account balances, are calculated based on pre-defined annual pay credits and interest credits. For this reason, the benefit calculation and account balance structure of cash balance plans are typically easier to understand.
Similarly to traditional defined benefit plans, cash balance plans can be attractive to small business owners who want to save significant amounts of money each year and benefit from a more intuitive account balance structure, and are also willing to accept minimum funding requirements, higher annual fees, and annual administrative requirements.
As a small business owner, choosing the retirement plan that best fits you and your situation can be a tough decision. Whether it’s deciding between a defined contribution / IRA-based plan or a defined benefit plan, or deciding between the types of defined benefit plans, selecting a retirement plan can help lay the groundwork for a successful retirement. If you are looking for assistance as you navigate this decision, contact us at Dowling & Yahnke Wealth Advisors, and our team would be happy to help.