Personal Defined Benefit Plan: Your Top Questions Answered

Have questions about our Personal Defined Benefit Plan? Here are responses to some common questions.

Qualifications

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 (if you were born before July 1, 1949) or age 72 (if you were born on or after July 1, 1949).  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.

Contributions

When your plan is set up, your expected annual contribution level will be based on your desired level of annual savings until retirement and must conform to IRS rules. To properly design the plan, you must choose an anticipated retirement age and also provide an estimate of future pay for yourself and your employees. This information is required because the IRS limits for each participant’s benefits are adjusted for age at retirement, the number of years participating in the plan, and pay earned while participating in the plan. Schwab uses this information to design a customized benefit formula for the plan.

This should be your best estimate of when you expect to stop working and retire. When you stop working, you will terminate the plan and have the benefits distributed to you (and your employees, if applicable). For most plans, the age you select will become the normal retirement age (NRA) under the plan. IRS rules specify that the NRA must be a reasonable estimate of actual retirement. It could be challenged later by the IRS if you ultimately retire at a different age.

No. However, IRS limits do apply to the ultimate annual lifetime benefit you can receive at retirement, and these limits could affect your contributions. For example, if your projected benefit payout goes above the limits, your desired annual contribution level will be reduced. The IRS also has rules for how the maximum annual benefit level is translated into a maximum lump sum available at retirement. The maximum lump sum is calculated based on legislated interest rates and mortality assumptions.

The benefits earned each year in the Schwab Personal Defined Benefit Plan must be the same percentage of compensation, or the same fixed dollar amount, for all employees, so an employer must consider the impact of providing a benefit to all eligible employees regardless of age or income. For example: If a 55-year-old owner has one employee age 35, annual contributions could be approximately $140,000 for the owner and $20,000 for the employee.

For a plan that has a January 1 to December 31 plan year, the contribution must be made before you file your business tax return for that calendar year, but not later than September 15 of the following year. If the plan is underfunded according to IRS rules, you will be required to make approximately 25% of the annual contribution on a quarterly basis (on April 15, July 15, and October 15 of the plan year, and on January 15 of the following year).

This is generally calculated and communicated in the fourth quarter of a particular plan year. However, Schwab can provide estimates earlier, if desired. For some plans it will be necessary to wait until the end of a plan year, when actual pay levels for each participant are known. In that situation, the contribution will be determined after the end of the plan year, but before taxes need to be filed.

Each year we will communicate the IRS minimum required contribution and the IRS maximum allowed tax-deductible contribution. You have to contribute at least the minimum, and no more than the maximum, or you will face excise tax penalties (10% of the shortfall/excess per year) and possible disqualification of the plan. The contribution amount will be adjusted every year, taking into consideration the value of assets in the plan. If past investment returns have been better than expected, this will decrease future contribution amounts; the inverse is also true. Before you start your plan, you need to be comfortable with the fact that contribution requirements can move up or down depending on asset performance.

Your plan may need to be amended to reduce the projected benefit payable at your expected retirement age. Note: Amending your plan will result in added fees for the work needed to design a new benefit formula and draft documents for signing. If your income were severely reduced such that the continuance of your business was in question, it might be appropriate to terminate your plan.

For a January 1 to December 31 plan year, the deadline to increase contribution levels for the current plan year is March 15 of the following year. To allow time for meeting that deadline, you need to let Schwab know of your situation by December 31 of the plan year.

IRS rules require that the plan document define a lifetime annual benefit payable at retirement and specify how it will be earned over a participant’s career. A formula is designed so that the desired level of savings (limited by IRS rules) is expected to result in sufficient assets to pay the benefit at retirement.

Yes. However, the contribution made is a tax deduction only from the business income of the entity sponsoring the plan. Therefore, you may borrow from another source to meet a particular year’s contribution, but the deduction can only be applied against the business income of the sponsoring entity.

In some instances, making contributions to a defined benefit plan and a defined contribution plan will cause an employer to exceed the IRS limit on annual employer contributions to all employer plans. Under 2006 Pension Protection Act legislation, your business can make employer contributions to a defined contribution plan of up to 6% of compensation (with each employee’s compensation capped at the IRS limit). Therefore, if you exceeded the 6% limit, it would not be possible to set up a defined benefit plan for the current year (unless your defined contribution plan allowed for a return of employer contributions to the employer under certain circumstances).

Each employee is allowed to make 401(k) salary deferrals (up to IRS limits) each year. These do not count toward the IRS limit on annual employer contributions to all plans of the employer.

Unexpected Events

The IRS requires that a defined benefit plan be used as a tool to provide for retirement income and not solely as a tax shelter. Under normal circumstances, you would maintain the defined benefit plan as long as you run your company and are able to make required contributions to the plan.

Your contributions each year depend on a particular length of time until retirement. If you decide to change your anticipated retirement age, or have a need to retire suddenly, there could be a mismatch between the amount of assets needed at termination and the amount actually in the plan. Therefore, it is extremely important that you alert Schwab about changing retirement dates as soon as possible, to allow enough time to change contribution levels over the remaining life of the plan so that all benefits can be paid.

You must have a “valid business reason” to terminate the plan. Your retirement from employment would constitute a valid reason. Retirement is when you stop working and stop earning income from your company. At retirement, you generally will terminate the defined benefit plan and distribute benefits to all employees. Another reason might be the inability to generate enough business income to make required contributions to the plan. You should consult with your attorney to see if specific situations would meet IRS requirements.

The IRS may audit any plan that was terminated. If a “valid business reason” is not found for terminating the plan, penalties may be imposed, including disallowing prior tax deductions. This risk may be increased in situations where the business continued in operation following the plan termination.

The benefits paid to participants may not exceed IRS limits. At termination, it might be possible to amend the plan to expand benefits up to the IRS limits, and use up some of the excess assets. But if benefits are already being limited by the IRS limits, then the plan will have excess assets at termination. Unfortunately, these assets cannot be simply returned to the sponsor. Technically, you may withdraw excess assets from the plan, but only after paying a 50% excise tax, and income taxes, on the amount of overfunding. In effect, this results in paying 85% of the excess assets to the IRS. Any change in the anticipated retirement age needs to be disclosed to Schwab immediately.

If you continue to work past your expected retirement age, your benefit will generally continue to grow, allowing for continuing contributions. You may need to amend the plan to change the benefit formula to result in a higher benefit or to allow service counted under the formula to exceed a limit written into the original formula. Amending your plan will result in added fees for the work needed to design a new benefit formula and draft documents for signing. An extended retirement age will likely reduce contribution levels from prior levels unless the plan can be amended. Also, if you have reached the IRS limit on benefits at the time you change your anticipated retirement age, it may not be possible to make any additional contributions to the plan.

Your employment with the other entity, and the related pay, cannot be included for your defined benefit plan. You will continue to only include your self-employment income for the purposes of your defined benefit plan. Contribution levels will need to be recalculated and the plan may need to be amended to reflect lower self-employment income. If your self-employment income decreases significantly, it might be considered a valid business reason for terminating your defined benefit plan.

Assets will be paid out to your designated beneficiary. Since the death benefit is based on the plan’s benefit formula, the situation described above ("What if I retire earlier than my anticipated retirement age?") regarding the possible mismatch between actual assets and those needed to pay the death benefit is relevant.

Assets

While it might make sense to terminate your current plan(s) and move the money to another investment vehicle in certain situations, you will not be allowed to roll over assets in your current plan(s) to the Schwab Personal Defined Benefit Plan. Therefore, you will need to roll money over to another type of account, such as an IRA.

Due to IRS employer contribution limits, when you sponsor a defined benefit plan there will be additional limits on employer-based contributions to your other plans. However, you could continue to make 401(k) employee deferrals and catch-up contributions to the old plan(s). These might be reasons to keep a prior plan active, rather than closing it and rolling funds to an IRA.

No. Contributions and accumulated assets are held in a single Schwab Personal Defined Benefit Investment Account, which is a brokerage account that is specifically designed to hold assets of qualified plans. There are no individual participant accounts set up.

All assets for funding the plan must be held in a Schwab Personal Defined Benefit Investment Account. You may select from a wide range of investments, including stocks, bonds, mutual funds, exchange-traded funds (ETFs), and certificates of deposit (CDs).

The plan will be established and sponsored by your business entity (corporation, company, partnership, sole proprietorship, etc.). The assets are "owned" by the plan, and are used solely to pay participant benefits. The business entity sponsoring the plan will be responsible for making the contributions needed for paying retirement benefits. After the contributions are submitted to the plan, they may only be used to pay plan benefits. There are severe penalties for using the assets for any other purpose.

An annual return of less than 6% will increase your future contributions, since the shortfall in the return would need to be made up in the future by increased contributions to meet the projected target plan benefit. Similarly, an annual return of greater than 6% will decrease your future contributions. The impact of investment performance—higher or lower than expected—increases over time as your assets grow and you get closer to retirement. Therefore, it is very important to take asset performance volatility into account when selecting investments.

Plans Sponsored by a Partnership

No. The defined benefit plan will maintain only one account for all the plan assets. However, for the purpose of the annual contribution, assets per partner will be tracked, and the amount of the annual contribution per partner will be provided to the partnership for deductibility purposes. When a partner retires, all the assets in the plan may be used to pay that partner's benefit. Because assets are pooled to pay all benefits under the plan, partners need to agree on the investment policy before they decide to open a defined benefit plan.

Schwab's prototype plan document does not allow for excluding partners from participating in a defined benefit plan

Distributions

Participants may not take ANY distribution until termination of employment. You will receive a distribution only after you terminate employment, or at the end of the plan termination process, if later. But there is one exception, as explained in the question below ("What are the options for taking benefits from the plan?").

The defined benefit plan allows you to roll over the total value of your retirement benefits to an IRA after you retire. The money then becomes subject to IRA withdrawal rules. You could also take a full cash payment rather than a rollover (subject to mandatory 20% withholding taxes). Alternatively, you could draw a monthly benefit (but this requires you to maintain the plan, which requires continuing administrative fees), or you could purchase an annuity from an insurance company.

When an owner of the business reaches age 70½ (if you were born before July 1, 1949) or age 72 (if you were born on or after July 1, 1949), he or she must begin withdrawing annual payments from the plan. These annual payments are taxable as income and may not be rolled over to an IRA. 

No. Participants may not make a withdrawal from the plan in an emergency—not even a hardship withdrawal.

No. The Schwab Personal Defined Benefit Plan does not allow loans from the plan.

Fees and Services

Yes. They are a deductible business expense in the year they are paid. Please refer to the Schwab Personal Defined Benefit Plan information sheet for additional information.

You should not pay plan fees out of the defined benefit plan account. Contribution calculations do not factor in the payment of expenses from the plan. Fees should be paid from the general assets of your business.

Yes, without submission to the IRS: $1,500, plus $250 for each participant in excess of two 

With submission to the IRS: $3,000 to $3,750, plus applicable IRS filing fee, currently $3,000. The IRS reserves the right to change the filing fee at any time. 

PBGC-covered plans: $400 for request to remove coverage only; $800 for PBGC standard termination

Termination services include all government forms required for terminating the plan and filing for qualification with the IRS. Services also include potential interaction with the IRS to provide historical information and answer questions related to the plan. The termination process can take up to a year or more due to IRS timing rules and approval and/or processing of certain documents.

No. Schwab is not able to administer a plan document that has already been established by another provider. You would need to terminate your current plan and start up a new defined benefit plan with Schwab (additional fees would apply).

You may hold assets for your plan in a Schwab Company Retirement Account (CRA), where you can benefit from a wide range of investment choices, including stocks, fixed income investments, mutual funds, ETFs, and CDs. Please call 800-435-4000 or contact a Schwab investment professional to receive information or set up an account.

Schwab only administers plans with a January 1 to December 31 plan year. If your business has a non-calendar fiscal year, you will need to work with your accountant to determine how to allocate the defined benefit plan tax deductions to each fiscal year.

Statutory Requirements

No. It does not require any state's approval.

Schwab fees include providing the Form 5500 for your Personal Defined Benefit Plan each year.

Yes. The maximum amounts increase by cost-of-living adjustments. If your benefit is affected by the IRS limits, then your contributions could increase a little each year due to increases in the IRS limits.

For owner-only plans and most owner-and-spouse plans, benefits are not protected from creditors. You will need to consult your attorney and/or tax advisor to determine how you would be affected.

You will need to pay PBGC premiums only if your plan becomes a "covered plan" under PBGC rules. A plan is generally covered unless it only provides benefits to owners/partners or to owners/partners and their spouses. Also, a defined benefit plan is not covered by the PBGC if it is established and maintained by a professional service employer and has fewer than 25 active participants. A law firm or medical practice is an example of a professional service employer. Contact your accountant and/or tax advisor for the PBGC’s definition of a professional service employer.

Law requires that the plan sponsor and other plan fiduciaries who have responsibility to direct and control plan assets be bonded by a fidelity bond. Plans that only cover the owner or the owner and spouse are not subject to this rule. The fidelity bond protects the plan against loss by reason of acts of fraud or dishonesty on the part of the plan official. The amount of bond required is based on the amount of plan assets.