Self-Employed? Consider a Solo Defined Benefit Plan

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by Advice Chaser
by Advice Chaser
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If you’re self-employed, you may think that retirement plans aren’t in your books, but you would be wrong. There are several options available for self-employed individuals to help them save for retirement. One of the most powerful tools, if used correctly, is a solo defined benefit plan: basically, a pension you set up and pay for yourself.

Without a doubt, a financial advisor is crucial to determining what retirement pathway is best for you. But it always helps to educate yourself about the tools at your disposal. 

What is a Solo Defined Benefit Plan?

Solo defined benefit plans are ideal for self-employed individuals, especially those with high income. Your salary and the length of your employment determines your benefits. Unlike other retirement funds, the payout is “defined” and is not affected by investment returns. You receive benefits either as fixed monthly payments or in one lump sum. 

Essentially, you are setting up your own pension fund. You pay more than a traditional retirement account, and take on a higher administrative burden. But the expense pays for itself when you consider the amount of pre-tax contributions you can make.

The great benefit is that you can imbue a great deal of cash into this particular plan even in a short amount of time, especially when combined with a 401(k). If your current income is enough to guarantee at least $50,000 in savings before taxes, then it’s an ideal way to ensure you have a comfortable retirement. If you don’t think it’s possible to meet that threshold, you could achieve similar benefits with other plans. The extra administrative costs won’t pay off unless you save quite a bit each year.

How It Works

When you set up a solo defined benefit plan, you know exactly what you are getting into when you retire. At the time you establish the plan, you define the benefits. Benefits may be calculated by your salary history and length of employment or be set at a fixed dollar amount. As both the employer and the employee, you make the decisions and pay all the contributions.

Limits:

Generally speaking, the annual benefit cannot exceed either 100% of the employee’s average salary for their three highest-earning consecutive years or $230,000 (as of 2021). This number shifts every year due to cost of living. That’s much higher than a 401k allows, which is $58,000 between both employer and employee contributions. So a defined benefit plan can help high earners save much larger amounts for retirement.

If you have a family business, contribution limits multiply once parents, spouses, siblings or children also use the plan. 

Contributions:

Employers make the contributions but employees may do the same. Compared to other retirement plans, both contributions and deductions are higher than usual, which only benefits you. 

Maintenance costs:

If you have employees, the administrative cost rises, as you will need to contribute on their behalf on top of paying for the maintenance fees. Unlike defined contribution plans, defined benefit plans are managed entirely by the employer. Again, if those employees are just you and/or your family, the long-term benefits outweigh the initial costly investment. 

Filing and Taxes: 

Each year you will need to file Form 5500, with an enrolled actuary being the one to sign the Schedule B. 

If the minimum contribution requirement isn’t met or if contributions exceed the set limits, then excise taxes may be applied. These are hurdles that a financial advisor can help you through.

Tax Savings:

Besides the retirement aspects, a defined benefit plan can also help you pay fewer taxes as a self-employed individual. 

Contributions to your defined benefit plan are tax deductible and distributions are taxed as income. This results in large tax deferrals. Especially if you are maximizing your 401(k), you could manage to significantly lower your tax bill in the current year while ensuring a comfortable future once you’re ready to retire. 

Should You Consider a Solo Defined Benefit Plan?

It’s never too early or too late to begin saving for retirement. For self-employed individuals, a solo defined benefit plan can help do that. To determine the best strategy for your retirement savings, contact us to reach an experienced financial advisor.

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