Q. After many years of struggle, I seem to have hit my stride with my business. When I started my business, someone told me to “keep it small, keep it all.” I didn’t listen and in the past have had numerous employees that turned out to be more of a headache than an asset. I’m now down to just myself and one loyal administrative person. I’m in my 50s and she is in her 30s. I need to play catch-up with my retirement funding and have read about a defined-benefit plan but am skeptical about the plan. The main questions I have are: 1) If I contribute for myself I know I also have to contribute to my employee but at what level? 2) Once I start the plan, am I committed to fund it and if so, for how long? 3) Is this a costly plan?
I desire to work until I am in my late 60s and don’t anticipate any reason my business income will decline drastically, do you think this type of plan is suitable for me?
A. You may be the ideal candidate for a defined benefit plan (DBP) but it is a commitment and you are wise to question whether it is right for you. A consultation with an expert in this area is advisable. I contacted Kevin Donovan, managing member of Pinnacle Plan Design, in Tucson, Ariz., for assistance in answering your questions. DBPs have very high contribution limits, as much as $200,000 to $250,000 for those in their 50s with the right work and earnings history.
The contributions are generally 100 percent tax deductible, grow tax deferred and are taxable when withdrawn. The amount of the contribution is based on age, the number of years to retirement, compensation, previous earnings and years of service. The amount is also based on a projected monthly payment in retirement. Contributions must be made for all eligible employees. If these employees are much younger and have a much lower income than you, the business owner, the required contributions made on your behalf will be substantially higher than theirs.
There are higher costs and administrative requirements with DBPs than with other retirement plans available to a small business owner. You will need to hire a firm to perform annual actuarial calculations and an IRS Form 5500 will need to be filed annually. With few exceptions, withdrawals before age 59 ½ will be subject to a 10 percent penalty in addition to ordinary income tax. Required Minimum Distributions (RMDs) for a business owner must begin at age 70 ½ (or April 1 of the year thereafter) even if still employed. If RMDs are not taken, there is a 50 percent IRS penalty.
The biggest downside of a DBP is the required funding. To be compliant with the IRS, the plan has to be in place for at least five years. You must fund the minimum amount each year or your plan will be in violation which will cause many problems. You must be prepared to not only fund the plan at the minimum level but also be prepared for additional funding should the plan value decrease significantly due to investment performance.
Overfunding can also be problematic.
Donovan, provided the following explanation. There is always a limit as to what can come out of the DBP based on a number of factors, most importantly age and years in the plan at time of distribution. If you were to fund the plan to the maximum amount allowed and then had to unexpectedly terminate the plan because of death, disability or the like there is a maximum amount that can be withdrawn. If the account value is greater than this amount, the plan is “overfunded” and this amount reverts back to the business. The entire reversion amount is taxed at ordinary income and there is a 50 percent excise tax on reversions. If you were in the 40 percent tax bracket the IRS would take 90 percent (40+50) of the overfunded amount. If you want to make the maximum contribution, Donavan recommends making the minimum contribution this tax year and waiting to add the additional amount in January 2014.
Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624