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September 10, 2006 at 04:00 PM
So your 50-something client realizes (with or without your help) that or he or she may not have enough money “socked away” for a comfortable retirement. A defined benefit pension plan may be the ideal solution.
Defined benefit plans have been out of vogue for some time, due in part to their relative lack of flexibility and potentially costly administration. However, a DB plan may be just the thing for those who need to build a nest egg in short order.
A well-designed DB plan lets business owners save, on a tax-deductible basis, from 5 to 10 times the amount of money permitted in a defined contribution plan. This is possible because the IRS controls the plan benefit, not the contribution, as it does with 401(k)s, SEPs and IRAs. As long as the plan gives the same benefit to all employees, the IRS permits the company to contribute whatever amount necessary to fund the benefit.
For example, a company could adopt a DB plan that promises retired employees 50% of their salary (up to a salary cap of $220,000 in 2006) when they reach 65. If the workforce consisted of just two employees, the plan might go something like this:
Employee #1, age 55, is the owner of the business and earns $200,000 per year. Employee #2, age 30, earns $40,000 per year. The DB plan promises to pay employee #1 $100,000 per year after retirement and employee #2 $20,000 per year at retirement. Because the benefits are applied in a non-discriminatory way, the IRS is happy.
The company now must set aside money to deliver on the plan promises. Specifically, the firm has 35 years to accumulate enough money to fund a $20,000 annual benefit to employee #2, but it only has 10 years to fund the promise to pay $100,000 per year to employee #1. The company will be allowed a deductible pension deposit in the neighborhood of six figures. If the company is profitable and looking for big deductions, it too is happy.
Because of the differences in their ages and compensation, most of the contribution for this plan will go to build a fund large enough to provide the benefit promised to the owner of the business. Now, the business owner is happy.
