Small Company – Defined Benefit Retirement Plans

Many small businesses owners are finding it difficult to provide adequate retirement for themselves through company sponsored retirement plans. The Employee Retirement Income Security Act, also know as ERISA has strict rules governing how much money can be put aside for owners of businesses and their employees in retirement plans. These plans have many names. The most popular are SEPs and 401(k) defined contribution plans. Defined contribution plans are characterized by specified contribution formulas that are usually expressed in a percentage of salary. The 2006 contribution limitation on many plans is $44,000. In some cases the $44,000 maximum contribution may be reduced by a lack of employee participation in the plan.

Employers are now turning in increasing numbers to more traditional retirement plans know as defined benefit plans. These plans were once very popular. However, they lost their popularity as companies shifted the burden of retirement to employees, utilizing defined contribution plans like the 401(k) to reduce employee retirement costs. The trend towards defined contribution plans began to shift back towards defined benefit plans when Congress enacted the Economic Growth and Tax Relief Reconciliation Act of 2001 “EGTRRA”.

The act modernized the contribution limitations and benefits a participant could receive in a defined benefit plan. The act also revived a type of small business defined benefit plan known as 412(i). The 412(i) plan is a defined benefit plan that is funded with fixed annuities and in most instances contains cash value life insurance. The inclusion of this plan in the tax code was designed to allow small business the ability to sponsor these plans at a reduced administrative and ERISA compliance cost. Traditional defined benefit plans involve four parties to install the plan. The parties include sponsoring company, a third party Administrator/Actuary, the IRS, and the company accountant. Costs can vary depending on the amount of employees that participate. Implementation and annual administrative costs can range from as low as $2,500 for very few employees to thousands of dollars for larger companies with many employees. A 412(i) plan eliminates much of this cost and reduces the administrative burden on the company.

However, the plan is designed for small employers with few employees. For example let’s take a look at a fictitious medical practice. The practice has one owner, Dr. Jones. The doctor employs four people, a nurse, a receptionist, and a bookkeeper. The doctor is 50 years old and his staff is somewhat younger. The nurse is 35, the receptionist is 25, and the book keeper is 30.

The doctor decides to look into a 412(i) plan because his accountant tells him he needs to save more for retirement. He is concerned with costs but really wants something he can contribute as much money as possible into. His children are all married and out of his house and he finally has the money to save. If the doctor’s salary equals or exceeds the IRS’s salary computation limits, which is currently $215,000, his P.A. could make an annual tax deductible contribution in excess of $158,000 on his behalf. This may provide the doctor with over $175,000 a year of lifetime income beginning at age 65. That is approximately 80% of his current income. The contributions for the employees will be calculated the same way the doctor’s contributions were determined. The doctor has only 15 years until retirement while his oldest employee has 30 years to reach retirement age. If the nurse was earning $50,000, he or she may receive $40,000 or 80% of their salary in retirement. The contribution to make that happen is approximately $17,000 annually. The doctor’s P.A. was able to move significant tax deductible contributions to the plan. The chart below illustrates the contributions of a defined benefit 412(i) plan.

Defined benefit plans don’t work in every business situation and careful consideration is necessary before any plan should be implemented. If a plan does fit well with the owners objectives, then a defined benefit plan may provide a great way to reduce taxation, increase retirement funds, provide valuable insurance protection, and eliminate unnecessary pass-through income.