DB vs DC: Choosing the Right Retirement Path for You and Your Business
Rohit Punyani, Co-Founder • December 28, 2023
A Guide to Understanding the Distinctions Between Defined Benefit (DB) and Defined Contribution (DC) Plans for Business Owners.
Getting to Know Defined Benefit (DB) and Defined Contribution (DC) Retirement Plans
What is a defined benefit plan?
First, let's break down the key features of defined benefit and defined contribution plans. Starting with defined benefit plans—which provide a specific benefit at retirement for each participant. The most common example of this is a pension.
Many employees value a pension because it is fixed in terms of its payout, and considered more secure because of the reliable, stable, predictable income it offers its participants and owners. To this day, employees still value and gravitate toward corporations that offer a defined benefit program.
👉For small business owners, one type of defined benefit plan is 412(e)(3) plan but more on that below.
What is a defined contribution plan?
In a defined contribution plan the actual amount of retirement benefits depends on the amount contributed to the plan, the investment vehicles chosen, and the gains and losses within the account.
An example that we all understand is a 401K plan. In a 401K plan, each participant decides on their contribution amount and chooses their investments. For business owners, 1099 employees, and other entities it is possible to create your own defined contribution plan that is not only much larger than a 401K but also can have some of the attributes of a defined benefit plan. This is called a cash balance plan.
Are DB & DC Plans my only option? | Hybrid Plans
Many business owners wish they could have the best of both worlds with their retirement plan, combining the large benefit and tax deduction provided by a DB plan with the flexibility of a defined contribution plan such as a 401(k).
Given that a Defined Benefit (DB) plan involves a pre-tax deduction into a distinct legal entity established for the benefit of employees and owners, it offers some flexibility in its design.
However, achieving this perfect blend requires a nuanced understanding of specific retirement options. To explore these hybrid solutions more thoroughly, let's delve into two distinctive approaches: the Cash Balance plan and the 412(e)(3), each presenting unique features and benefits.
Cash balance: a "hybrid" plan that combines the flexibility to include marketable securities as well as traditional risk-free insurance-based assets.
412(e)(3): is often referred to as a "fully insured plan," or a traditional pension. The plan is funded exclusively with insurance products: annuities and life insurance. Notably, 412 plans boast significantly higher contribution limits than cash balance plans and 401(k)s due to the riskless nature of their IRS-mandated fulfillment vehicles. They also provide an opportunity to achieve retirement goals without exposure to stock market risks on the principal.
“Did You Know The U.S. Tax Code Offers Unique Considerations For Life Insurance?"
Life insurance inside a DB plan, and ONLY life insurance, can be withdrawn from the plan without triggering taxes. Once outside the plan, life insurance continues to grow tax-free, risk-free, creditor-protected, and bankruptcy-remote. It also provides tax-free cash flow, estate planning features, and living benefits without market risk.
Why a Cash Balance Plan Might Be Right for You
Now, let's delve into the details of cash balance plans, which are generally more applicable, and many rules and regulations are the same for both.
👉Before we begin, it's important to note that this type of plan is not a do-it-yourself project; you will need to hire an experienced company to design and run the plan. At Fusion Strategies, we specialize in these plans and can customize the best plan for your business.
Characteristics of a Cash Balance Plan
Navigating the landscape of retirement planning often involves evaluating specific characteristics unique to each plan. A Cash Balance Plan stands out for its versatility and potential benefits. Unlike other retirement vehicles, a Cash Balance Plan provides flexibility in investment choices, allowing participants to invest in securities like stocks, bonds, and mutual funds. Additionally, it allows for the holding of cash, offering a secure and conservative option for those seeking stability.
The plan further distinguishes itself by mitigating risk and volatility, providing participants with options such as purchasing life insurance and annuities. Notably, contribution amounts in a Cash Balance Plan are determined first by employee salary and age - older or higher compensated employees may contribute more to a cash balance plan.
This represents a significant advantage for business holders who are older and looking to support their retirement while retaining and incentivizing younger employees with a plan.
Benefits of a Cash Balance Plan
Introducing a Cash Balance Plan can bring many benefits to businesses, going beyond the usual retirement options.
One notable benefit is the significant reduction in corporate tax liability. Most expenses afforded to business owners involve the purchase of a liability. For example, a high-tonnage vehicle or other expenses such as supplies, etc.
A cash balance plan is a tax deduction to acquire an asset - in effect, you are getting a subsidy to purchase assets that will grow tax-deferred and support your retirement.
Moreover, a Cash Balance Plan allows for higher contribution amounts compared to traditional 401Ks, providing a substantial advantage for business owners looking to maximize their retirement savings.
Additionally, the plan serves as a powerful tool to attract and retain top talent. As business owners and entrepreneurs finding and retaining key employees is a significant challenge. One way to differentiate yourself from the competition is to offer a cash balance plan
General Guidelines for Implementation
Embarking on the implementation of a Cash Balance Plan requires careful consideration of various guidelines and rules.
Here's a simplified list detailing key considerations for a smooth implementation:
Requires Annual Funding:
• Regular funding is essential to keep the plan active and effective.
Cash Flow Commitment:
• The plan sponsor needs consistent cash flow for annual funding, with a recommended commitment of at least three to five years.
Employee Coverage:
• All employees working 500+ hours per year must be covered, starting after one year of employment.
Handling Departures:
If an employee leaves before vesting, their contributions stay in the plan, ready for future use or surrender back to the business.
Scalability:
• Versatile implementation for companies ranging from 1 to 250 employees.
Tax Structure Flexibility:
•The plan is tax structure agnostic, meaning it can be seamlessly implemented for various business types, including C Corp, S Corp, partnership, sole proprietorship, LLP, or LLC.
How Does a Cash Balance Plan End?
Similar to the termination of a 401K, a Cash Balance Plan concludes with each employee having the opportunity to roll their proportional share into an individual IRA.
This seamless transition ensures that participants can continue managing their retirement assets with ease.
Key distinctions to consider when choosing a 412(E)(3) (defined benefit plan)
Considering these three critical distinctions is essential in determining the best option for your business, particularly when it comes to the 412 plan (defined benefit plan
Let’s dive into the key distinctions:
Suited for Small Companies:
•412 Plan (Defined Benefit): is suited for very small companies, sole proprietorships, or single-person structures.
Investment Constraints:
•412 Plan (Defined Benefit): Constrained to invest solely in insurance and annuities due to being a defined benefit plan, avoiding any risk associated with marketable securities.
Contribution Dynamics:
• 412 Plan (Defined Benefit): Contribution amounts are higher due to fully insured products with a slightly lower rate of return, prioritizing lower risk.
Key Questions for Consideration when choosing a 412(E)(3) (defined benefit plan)
To determine which plan aligns best with your business, ask yourself these key questions:
Commitment to Contributions:
•Are you willing and able to contribute consistently for three or more years at a level amount?
Talent Attraction and Retention:
•Are you seeking to attract and retain top talent within your organization?
Retirement Savings Enhancement:
•Do you aim to enhance your retirement savings substantially?
Tax Minimization and Asset Subsidization:
•Do I want to minimize taxes and subsidize asset purchases?
Utilization of Insurance for Financial Strategies:
•Am I open to using insurance to boost retirement spending, reduce taxes, and initiate or complete an estate plan?
In the complex world of retirement planning, the right path can significantly impact your business's financial future. If you find yourself navigating the complexities of defined benefit and defined contribution plans, Fusion Strategies is here to be your guide.
Our team is ready to collaborate with you, offering tailored solutions that align with your business goals. Let's work together to transform corporate expenses into personal assets, providing you with a retirement plan that not only minimizes taxes but also maximizes your financial well-being.
Contact Fusion Strategies now and embark on a journey to secure a prosperous retirement for both you and your business.