Have questions about our Personal Defined Benefit Plan? Here are responses to some common questions.
The type of retirement plan your business should sponsor depends on a number of factors, including how many persons you employ in addition to yourself, your income level, your age, and when you’d like to retire.
The IRS has strict required minimum contribution rules. And should investment losses occur, your required contributions may increase. It is important to have steady income to meet these needs. Remember, a defined benefit plan is not like a profit-sharing plan, in which a sponsor can suspend contributions in certain years. If the sponsor contributes less than is required, the IRS will impose excise taxes, and may disqualify the plan and disallow past tax deductions.
Annual funding contributions are generally substantial amounts. This means you will need significant future earned income so that you can make contributions and still have enough money for other purposes. We estimate that earnings, before considering the defined benefit plan contribution, need to be $250,000 or more per year to make the cost of running the plan low relative to the tax savings. High earnings are also important because IRS benefit limits are based on the highest three consecutive years of net earnings. High earnings ensure that a high target benefit can be established for the plan, which leads to higher contribution levels.
Compensation must be earned income from active employment in the business sponsoring the plan. Generally, this is all income that is subject to FICA taxation. For a sole proprietor, compensation would equal net earned income from the business after deducting employer FICA taxation and qualified retirement plan contributions. This can also include W-2 earnings if the business files as a corporation. Passive income such as rental income or shareholder income does not qualify.
Contributions to the plan are spread over the period from plan startup to the expected retirement date. The shorter this period, the higher each annual contribution needs to be so that enough assets are accumulated to pay the target benefit. Longer periods would result in low contribution levels. Starting the plan before age 50 would generally result in a very long savings period, and therefore annual contributions would be too low to justify a defined benefit plan.
Persons starting a plan when they are over age 65 are required to start withdrawing benefits at age 70½. Because the tax deferral period will be very short, the tax benefits may not outweigh the costs of running the plan.
The IRS expects a plan to be maintained for the purpose of accumulating retirement assets. Clients seeking short-term tax relief who do not expect to run the plan until the stated date they anticipate retiring from their company run the risk of the IRS disqualifying the plan as a tax shelter rather than a valid retirement plan.
This plan requires that all employees meeting eligibility requirements participate in the plan. The Schwab Personal Defined Benefit Plan must cover all employees who work over 1,000 hours per year. Therefore, all current employees (and all future new hires) working over 1,000 hours a year would earn benefits under the plan and would significantly increase plan costs.
Businesses under common ownership could be considered a single business for defined benefit plan participation and benefit coverage rules. For example, if you own or partially own two or more businesses (or your spouse also owns a business and you have a child under age 21), then ALL of the employees of all commonly controlled businesses could be required to be covered under your defined benefit plan. This could cause you to cover employees beyond your immediate business, which could significantly increase the contributions to the plan. You should work with your attorney and accountant to make this determination.
The benefits you earned under that previous plan will reduce the amount of benefits you earn under any new defined benefit plans. Therefore, if you earned a high benefit in a past defined benefit plan your business (or past business) sponsored, the amount you can target in a new plan would be reduced.
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