Defined Benefit Plan for the Self-Employed

A defined benefit plan is a retirement structure that guarantees a specific income upon retirement, functioning like a traditional pension with a predetermined monthly benefit for life. This contrasts with defined contribution plans, like a SEP IRA or Solo 401(k), where the outcome depends on contributions and investment performance. Defined benefit plans allow for very large, tax-deductible contributions, making them a compelling option for high-income self-employed professionals looking to accelerate their retirement savings.

Eligibility and Contribution Calculations

Eligibility extends across business structures like sole proprietorships, partnerships, LLCs, and S-corporations, provided the business generates earned income. For an S-corporation owner, this is the W-2 salary, while for a sole proprietor or partner, it is the net adjusted self-employment income. This income forms the basis for calculating contributions and benefits, making consistent profitability important for maintaining the plan.

Unlike simpler retirement accounts, annual contributions are not a set percentage of income. An enrolled actuary must calculate the amount needed each year to fund the plan’s future promised benefit. The calculation is based on several factors:

• The owner’s age, as older individuals have a shorter time to save and can make larger contributions.
• The owner’s compensation history, which is linked to the benefit formula.
• The specific retirement benefit being targeted, subject to an IRS-defined maximum.
• An assumed rate of investment return, typically a conservative figure around 5% to 5.5%.

For example, a 55-year-old earning $250,000 annually may contribute over $150,000 per year. A 40-year-old with the same income would have a lower maximum contribution, perhaps closer to $60,000, because their funds have more time to grow. This makes the plan advantageous for those in their peak earning years and closer to retirement.

Required Information and Documentation

Before establishing a plan, the business owner must provide key information to the Third-Party Administrator (TPA) or actuary. This data is used to create the governing legal documents.

• The owner’s full legal name and date of birth.
• The business’s legal entity type and tax identification number.
• The spouse’s date of birth, if applicable, for calculating survivor benefits.
• A comprehensive income history for the last three years to establish a compensation level.

Two legal documents form the plan’s foundation. The first is the Plan Document, which is the rulebook for the plan’s operation. It details the benefit formula, eligibility requirements, normal retirement age, and available distribution forms like a lifetime annuity or a lump-sum payment.

The second document is the Trust Agreement. This establishes a trust to hold and protect the plan’s assets for the participants. The agreement names a trustee, often the business owner, who has fiduciary responsibility for managing the plan. This structure shields the retirement funds from business creditors.

The Establishment and Maintenance Process

To establish a plan, a business owner first engages a TPA or actuary to prepare the Plan Document and Trust Agreement. The owner must sign these documents to adopt the plan by the last day of the business’s fiscal year, which for most sole proprietors is December 31. This makes the plan effective for that tax year.

Next, a dedicated brokerage or trust account is opened in the trust’s name to hold all contributions and investments. While the plan must be established by year-end, the first tax-deductible contribution can be made up until the business’s tax filing deadline for that year, including extensions.

Maintaining the plan requires annual administrative actions to ensure compliance. Each year, the actuary performs a valuation to certify the plan’s funding status and calculate the required contribution. This information is reported on Schedule SB, which is attached to the annual IRS Form 5500-series return that must be filed by the plan sponsor.

Coordinating with Other Retirement Plans

A self-employed individual can pair a defined benefit plan with a defined contribution plan, most commonly a Solo 401(k). This allows the owner to contribute to both structures simultaneously.

The business owner, as the “employer,” makes the large, actuarially determined contribution to the defined benefit plan, which is tax-deductible to the business. The owner, as the “employee,” can also make personal salary deferral contributions to their Solo 401(k), up to the annual IRS limit.

When using both plans, total deductible contributions are subject to overall limits. Because the defined benefit plan contribution is very large, it consumes most or all of the available deduction for employer contributions. As a result, the ability to make an employer profit-sharing contribution to the Solo 401(k) is significantly reduced or eliminated.

Distributions and Plan Termination

Upon reaching the plan’s retirement age, typically 65, the owner can begin taking distributions. Benefits are paid out in one of two forms. The first is a lifetime annuity, which provides a fixed, regular payment for the rest of the retiree’s life. This option provides a predictable income stream.

Alternatively, the owner can receive the benefit as a single lump-sum payment. Most who select this option execute a direct rollover of the funds into an Individual Retirement Account (IRA). This avoids immediate taxation and allows the funds to continue growing tax-deferred, giving the owner more control over investments and withdrawals. All distributions from the plan are taxed as ordinary income.

If business circumstances change, the plan can be formally terminated through a process managed by the plan’s actuary. The actuary performs a final calculation to determine the amount needed to fully fund all promised benefits. The owner must make any final contributions to ensure the plan is 100% funded before it can be closed. Once funded, the actuary files termination paperwork with the IRS, and the assets can be rolled over into an IRA.