Why a defined benefit plan can help a small business owner be ready now for retirement later

By Christopher Freeburn

While many small business owners may hope to fund their retirement through the sale of their business to employees or partners, for most small businesses that simply isn't a realistic option. Furthermore, with ever-greater numbers of people launching their small businesses as a second career, many small business owners are facing the prospect of looming retirement with relatively few years to contribute to their 401k plans. The same problem looms in the minds of professionals who have spent years slowly building their medical, consulting, and legal practices into highly successful enterprises and now find themselves wondering if they'll have enough investment income to retire comfortably. A potential solution for such high-income earners comes in the form of defined benefit pension plans, commonly called 412(i) plans.

Defining defined benefit
Defined benefit pension plans are employer-sponsored retirement plans whose future benefits are calculated ahead of time and paid out at a predetermined rate and schedule. Specifically, Internal Revenue Code (IRC) section 412(i) defined benefit plans are plans that conform to the 1974 Employee Retirement Income Security Act (ERISA), and are thus known as qualified defined benefit plans. Under a 412(i) plan, a small business owner can make fairly large, tax-free yearly contributions to the plan, which is funded with a combination of life insurance and annuities, or annuities alone. Unlike traditional 401k plans, 412(i) plans permit a much higher yearly contribution (as much as $195,000 for 2010), which permits the beneficiary to build up a sizeable retirement investment much more quickly than would otherwise be possible. (For a brief rundown of defined benefit plan characteristics, check out the IRS Retirement Plans Navigator: http://www.retirementplans.irs.gov/choose-a-plan/defined-benefit-plan/defined-benefit-plan/.)

"Defined benefit plans allow the larger contribution because the life insurance and annuities that fund the plans have a guaranteed rate of return that is generally much lower than in more traditional plans like 401(k)s," explains David B. Mandell, principal at Jarvis & Mandell LLC. "The guaranteed rate of return in these plans usually ranges between one to three percent, as opposed to four to six percent or more in a typical pension or retirement plan. In the latter, the employee's contributions are invested in market-traded securities, which can generate a much greater return, provided that market conditions are favorable." Defined benefit plans base their future value on actuarial data compiled by insurance companies, which calculate the likely life expectancy of the plan participant and structure the plan to pay out a predetermined distribution according to how much income the participant estimates he or she will need after retirement. The annual contribution (or premium) to the plan is determined by the desired size of future distributions.

High income, high contributions
Contributions to 412(i) plans are fully tax-deductible, a prospect that attracts the interest of many business owners. "412(i) plans allow for the largest pre-tax contribution of any qualified plan," observes Clint J. Lowery, executive case director at The Hartwood Group, which specializes in creating defined benefit plans. "Custom designed 412(i) plans allow a small business owner to retain the highest percentage of contributions for his or her own benefit." However, Lowery explains that the advantages of such plans only accrue to small business people with fairly high incomes. "412(i) plans must be funded in equal amounts every year. A person who is highly uncertain about having consistent revenue over, say, the next five years should not consider a 412(i) plan."

"These plans usually work best when the company owner is 10 years or less away from retirement and is considerably older than his employees," Mandell observes. Moreover, he says the stability of business income is an important factor. Since 412(i) plans are funded through insurance and annuity contracts, the yearly contribution is set at the outset of the plan and generally remains inflexible. If a business suffers financial reversals and finds that its annual revenues can no longer cover its contributions, cancellation of the plan is the usual result.

"Every company builds its own provision inside the policy to allow for business hardship," Hartwood's Lowery says. "Usually the plan would be terminated. Any annuity portion would be rolled into an IRA and any whole life policy would be converted to a universal life policy." However, Lowery points out that the annual contribution to the plan does not have to come solely from a company's revenues. "The money could come from retained earnings, a contribution of capital from the owner, or even a loan. If the company does not have enough revenue to take the full tax deduction for the contribution in the current year, the left over amount will carry forward."

Defined benefit plans are not just for high-income business or professional practice owners themselves. Employees can be included in the plans. "Depending on the business, it can be very expensive to cover all employees," explains Ridlon. "A dentist or a doctor might want to cover the nurses in his office, but not the other workers." In that case, specific formulas govern the number of employees that may be excluded from the plan.

Retirement isn't always the end
Building a legacy matters to many small business owners. As they look forward to their retirement years, they hope to insure for themselves a comfortable standard of living-one that ensures that they will be able to pursue new goals and interests after they leave the businesses they created. Proper financial planning can assure retiring owners a steady stream of income to support their new lifestyle and plans.

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