How Small Business-Owners Can Turbo Charge Their Retirement and Get a Tax Break
We’ve all heard that our tax code favors small business owners and real estate professionals, but few understand what that really means or where those tax breaks come from.
Enter the Defined Benefit Plan. While 401(k)s and IRAs are better known, these are considered Defined Contribution (DC) Plans which are different from Defined Benefit (DB) Plans in one very important way.
DC plans have maximum contributions set annually by the US government, and for high income earners, are well below the amount they can afford to save each year. DB plans are just the opposite; the amount one can save is reverse engineered, based on how much you make and thus how much you will need in retirement to replace your income.
So, how exactly does a Defined Benefit Plan work? Unlike a Defined Contribution (DC) Plan where contributions are made into an account that grows with investment returns, a DB plan guarantees a specific payout upon retirement. They calculate benefits using a formula which considers:
Average salary over a set number of years
Years of service with the company
Age at retirement
The formula looks something like: Benefit = (Average Salary) × (Years of Service) × (Benefit Multiplier). If you worked for 30 years with an average salary of $100,000, and the benefit multiplier was 2%, you would receive a benefit of $60,000 per year in retirement. The benefit multiplier percent depends on a multitude of factors: whether it is fixed and was set by your employer; whether it is variable and changed based on industry standards, unionized bargaining agreements, etc.
DB plans are standard for government/public sector workers, though they are also a viable option for small business owners. Many small business owners don’t consider them due to the significant planning they require and funding requirements. However, at Summit where we manage everything in our client’s life that has a dollar sign attached to it, this is all handled internally by our firm.
There are different variations of DB plans, but two common types are Traditional Defined Benefit Plans and Cash Balance Plans. The former promises a fixed benefit, and the business owner is responsible for funding the plan. The latter is a hybrid between DB and DC plans. They offer a set contribution to an individual’s retirement account each year, which grows based on a stated interest rate. For a small business owner, Cash Balance Plans may be a better option. They provide a simpler structure which makes them easier to implement and manage.
While the structure of Defined Benefit Plans is federal, certain state laws and tax considerations can affect them. For example, let’s take 3 states (California, Idaho, and Washington) to examine how state-level factors would affect small business owners.
California is known for its complex tax environment, and its treatment of retirement plans is no exception. While it largely follows federal guidelines for retirement plan contributions and distributions, additional considerations are as follows:
California does not offer tax breaks for employer contributions to DB Plans, but some other states do allow additional state-level deductions or credits.
Pension Protection Act: California has laws in place to protect retirement savings from creditors, which can be an important consideration if your business is facing financial challenges.
California businesses may be subject to additional compliance regulations, such as the California Privacy Rights Act (CPRA), which affects how retirement plan data must be handled.
Idaho’s tax laws are considered more business-friendly compared to California.
Like most states, Idaho taxes retirement plan distributions, but it does allow for more favorable tax treatment of certain pension contributions. Contributions to DB plans can reduce taxable income, benefitting business owners.
Idaho tends to have fewer regulations that impact the administration of retirement plans, which may make DB plans simpler to manage for small business owners compared to California or Washington.
Washington does not have a state income tax, which can be an advantage for business owners with Defined Benefit Plans:
Since Washington doesn’t tax income, there is no state tax on retirement income, which means business owners and their employees could benefit from tax-free distributions during retirement.
Washington follows federal guidelines regarding DB plan contributions, so business owners should be mindful of federal contribution limits and other related rules.
So, while Washington's lack of a state income tax is a major advantage thanks to potential tax-free retirement distribution, those in states like California may face higher tax burdens both on contributions and distributions (even though they are federally tax-deferred).
Like any retirement plan, DB plans come with a set of benefits and drawbacks, particularly for small business owners.
DB plan benefits include: allowing higher annual contribution limits than 401(k)s or SEP-IRAs, which helps save large sums for retirement in a short time frame; offering a predictable retirement benefit rather than being dependent on the performance of investments; making contributions tax-deductible; plan assets growing tax-deferred.
DB plan disadvantages include: being expensive to set up and maintain as they require actuarial services, plan administration, and ongoing compliance; requiring businesses to contribute a set amount each year, regardless of the company’s financial performance; having contributions not be easily accessible.
The tax treatment of Defined Benefit Plans is one of their most appealing aspects, especially for high-income small business owners. Contributions made to the plan are tax-deductible, which reduces the business owner’s current taxable income. Furthermore, earnings within the plan grow tax-deferred until retirement. At that point, distributions are taxed as ordinary income.
Defined Benefit Plans can be a valuable tool for small business owners looking to maximize retirement savings and secure a predictable income stream for retirement. However, they come complexities, including higher costs and administrative requirements. By understanding DB plans, business owners can make more informed decisions about how to approach their retirement planning. As always, we recommend working with a tax professional who understands both tax strategies and wealth management.