Pros and Cons of a Defined Benefit Plan for Self-Employed Professionals

Retirement planning is a top concern for self-employed professionals, and a defined benefit plan is one option to consider. The right choice for you will depend on a number of factors like your personal goals and income level, which you can discuss with a financial advisor.

What Is a Defined Benefit Plan?

Think of a defined benefit plan like a pension plan for independent professional employers. While this retirement option is more costly to implement and maintain, it does allow for significantly larger contributions than a solo 401(k) or an SEP IRA.

When you set up a defined benefit plan, you’ll work with an actuary to determine your retirement payout. The actuary will calculate your monthly or annual contributions based on factors like your chosen payout, age, and expected investment returns. Defined benefit plans can be complicated, but if you’re a high-contributor looking to maximize your retirement income, this might be the right plan for you.

Pros of a Defined Benefit Plan

A defined benefit plan has high contribution limits. Earnings grow tax deferred and are taxable when withdrawn at retirement. Contributions are also tax deductible as a business expense (within IRS limits), which helps to reduce your taxable income.

Defined benefit plans can be combined with other retirement options such as a solo 401(k), or an SEP IRA, which increases the amount you can save for retirement each year.

Lastly, this plan can help provide risk mitigation for your future finances because creditors cannot seize defined benefit plan assets. This means that even if your business is the target of a lawsuit, your retirement assets are safe—even in a worst-case scenario.

Cons of a Defined Benefit Plan

Defined benefit plans can be complicated to set up and costly to run. Plan on paying startup fees, administrative requirements including annual actuarial calculations, and filing fees for IRS Form 5500. You’ll also have to commit to funding your plan at a minimum level each year in order to meet payout requirements, regardless of how your business fares.

If your small business has employees, you are required to offer a defined benefit plan, which can be costly. These plans typically take at least three months to set up, so it’s important to factor this timeline into your planning. As with most retirement plans, early withdrawals are subject to penalties.

Defined benefit plans are best for independent professionals with high, stable incomes who want to quickly save for retirement and who have few or no employees. The ideal defined benefit plan candidate will be able to make annual contributions of $80,000 or more for at least five years.

Contribution Limits

• An actuary will determine annual contribution amounts based on many factors including age, compensation, and retirement age. These contributions cannot surpass the legal IRS limit ($275,000 for 2024).
• Employees are eligible for a defined benefit plan if they have worked more than 1,000 hours in a year, have been with your company for over one year, and are 21 years or older.

Defined Benefit Plan Example

Example: Small business owner

Chelsea, age 60, owns a small business and her average annual income is $400,000. She plans to retire when she is 70, and ultimately wants to set aside $1 million using a defined benefit plan. Working with an actuary, Chelsea determines that her monthly contributions will be $7,500, or $90,000 per year, to meet her goal.

This content from MBO Partners does not constitute legal or financial advice.