Self employed individuals and small business owners have the option to create their own Defined Benefit Plan.
A Defined Benefit Plan is a qualified retirement plan in which annual contributions are made to fund a chosen level of retirement income at a predetermined future retirement date. Contributions are made according to an actuarial formula to meet the target retirement income benefit. In 2015 and 2016, the annual benefit payable at retirement can be as high as $210,000 per year. As a result, annual contributions into a Defined Benefit Plan can be even larger than $210,000 in some cases in order to meet that level of retirement income target. There are a number of factors involved with this calculation.
How are the contributions into a Defined Benefit Plan determined?
Calculating the annual dollar amount that can be contributed requires a mathematical calculation performed by an actuary involving the following factors:
- Client's age - In general, the older the client then the larger the annual contribution that can be made into the plan.
- Client's income - The calculation is based on the average of the client's highest 3 years of income. The greater the income then the greater the annual contribution can be (up to certain limits). Depending on a client's income, the annual benefit payable at retirement can be as high as $210,000 per year in 2015 and 2016.
- Planned retirement age - In general, at least 5 years from the year the plan is adopted.
- Investment performance - In the years after the Defined Benefit Plan has been established an annual actuarial calculation is made based on the performance of the investments in the plan. The actual performance of the portfolio can impact the annual contribution amount that will need to be made so therefore having a portfolio that minimizes volatility is often prudent. When a Defined Benefit Plan is established there is an rate of return assumption that is factored into the actuarial calculation to determine the annual contribution amount that is necessary in order to fund the future retirement income benefit. Each year the actual return of the portfolio will be compared to the rate of return assumption. When the portfolio's actual return is greater than rate of return assumption then there will be a smaller required annual contribution. Conversely, when the actual return is less than the rate of return assumption then the annual contribution will need to be increased to make up the shortfall. On an annual basis, an actuary makes calculations to determine the amount needed to be contributed into the plan to ensure the future target retirement income goal is reached.
I am self employed, age 45 with no employees and I have $210,000 of net income for my sole proprietorship. Can I contribute $210,000 to my Defined Benefit Plan?
No. Calculating the annual dollar amount that can be contributed to a Defined Benefit Plan requires a mathematical calculation performed by an actuary.
I am self employed, age 45 with no employees and I had an income windfall this year and anticipate of $250,000 of net income for my sole proprietorship. I usually earn $50,000 in net income. Should I setup a Defined Benefit Plan?
No probably not. In order for a defined benefit plan to be a good option, the business owner should feel confident about being able to make the required annual contribution for 3 years. For example, a Defined Benefit Plan is not the correct choice for someone that anticipates an income windfall in one year, but then is unsure about being able to make the required annual contribution in future years. A self employed individual in this scenario may want to setup an Individual 401k instead due to the annual contribution flexibility.
The calculations of how much can be contributed to a Defined Benefit Plan can be a little tricky to understand, but contact us and we would be happy for you to speak with an actuary regarding your situation or to run a customized Defined Benefit Plan proposal for you based on your income. Also, utilize the Defined Benefit Calculator to give you an idea of how much you could contribute. Keep in mind, the calculator is for illustrative purposes and is an estimate. There are certain plan design options such as adding a 401k salary deferral option to the Defined Benefit Plan that can potentially increase the annual contribution amounts beyond what this calculator is showing.