One of the things all business owners need to think about is how they are preparing themselves for retirement– after all, your company won’t offer you anything without your planning. While most private companies offer their employees profit-sharing retirement savings plans like 401(k)s, it may make more sense for business owners to pursue a different route.
This article will briefly cover pensions and how defined-benefit plans can offer better benefits to business owners like a cash balance plan. In addition, the information in this blog will prepare you for in-depth conversations with a certified financial planner– I always recommend working with one.
What is a Pension Plan?
A pension plan is a form of retirement savings plan where the employer commits to providing a certain amount of income for the employee’s lifetime after retirement. Pensions have largely fallen out of use in the private sector but remain the number one choice for public employee retirement savings.
The two categories of pension plans are defined-benefit and defined-contribution plans. 401(k)s fall in the defined-contribution category, which isn’t what most people think of when they hear “pension.” Typically if someone is talking about a pension, they are talking about a plan in the defined-benefit category.
The shift in popularity is because 401(k)s are much more affordable for employers to fund and maintain. However, there are still cases where business owners may offer it to certain employees, including the owner. We’ll cover the advantages later on.
Basics of Defined-Benefit Plans
Also known as a qualified-benefit plan, this pension class is “defined” because the employer and the employee know exactly how the contributions will be made ahead of time. Unlike retirement savings accounts like 401(k)s, this plan does not depend on the profitability of investments.
There are some essential characteristics of a defined-benefit plan that all business owners should be aware of:
- This plan is entirely under the responsibility of the employer to fund
- The profits don’t typically rely on investment growth
- The employer is often on the hook to continue the financing of the employee’s spouse if the employee passes first
Advantages of Defined-Benefit Plan
It’s easy to see why a defined-benefit plan is more expensive for employers to offer than plans like a 401(k)– so why bother? Defined-benefit plans provide the highest contribution allowances while still allowing tax deferral.
These features make a defined-benefit plan ideal for older business owners nearing retirement who still need to make up a significant portion of their nest egg.
You may be a good candidate for a defined-benefit plan if you meet the following criteria:
- You’re the business owner
- You’re age 40 or older
- You’re older than about half of the other non-owner employees
- You expect to have steady income going forward
The codes and regulations surrounding retirement savings plans can be complicated. You should be aware of a few basic components while considering a defined-benefit plan.
- A defined-benefit plan is for long-term use. At a minimum, expect your plan to be active for at least five years.
- You are required to make annual contributions. As the business owner, you are the one monitoring and making contributions. These contributions must be made annually, within 8.5 months of the plan’s fiscal year-end.
The required contribution will fluctuate with investment returns. The expected rate of return for defined-benefit plans is about 5%. If returns exceed 5%, you may have to contribute less to stay within the cap amount. However, if the returns are lower than expected, you will be required to make up the difference with increased contributions.
Cash Balance Plan
Cash balance plans deserve a special mention. A cash balance plan is a subset of defined-benefit plans but offers some perks of defined-contribution plans like 401(k)s. For example, while typical defined-benefit plans don’t align income with investment growth, a cash balance plan offers security while opening the door for investment growth.
Cash balance plans are a popular option for business owners nearing retirement who want to pump up their nest egg. If this describes you, be sure to contact a professional financial planner soon so you don’t miss your window to increase your tax-deferred wealth significantly.
Keep in mind that the deadline for Setting up a Defined Benefit/Cash balance plan is the Tax filing deadline including extension.
There are many rules and regulations about deferred income, tax codes, and discrimination testing. But that doesn’t mean you can’t customize your retirement savings offerings to give yourself the best chance of a comfortable retirement.
At Blu Financial, we work with small business owners to connect them to the best possible products. We’re here to help you make your dreams a reality. Contact us today for a free consultation.