It's Not Too Late to Save for Retirement

A recent Gallup poll indicates that retirement savings are the top financial worry for Americans, with 52 percent citing concern over the size of their nest egg. For the significant baby boomer group on the cusp of retirement, this concern may be less about the income they have available to save and more about the short time they have left to save it.

Small-business owners with significant excess income, say $50,000 or more annually, are finding the $44,000 to $49,000 annual 401(k) limit to be, well...limiting. Many entrepreneurial boomers starting late in the game can only hope to accumulate $500,000 or $600,000 for retirement under these limits, money that won't even start to cover a retiree's cost of living expenses, let alone finance the fishing cabin.

But there is another option. Business owners in their fifties can leverage the high contribution limits of a defined benefit plan to contribute up to $200,000 annually, tax-deferred, toward retirement. The defined benefit plan, which can often be set up to work in conjunction with an existing 401(k) plan, is a great way for business owners aged 40 and older to pump up their retirement savings during their peak earning years.

What does age have to do with it? Unlike a 401(k) plan, which is a type of defined contribution plan, the defined benefit plan has limits imposed on the ultimate benefit that can be received. Business owners who have less than twenty years left until retirement have relatively few years to fund toward this maximum benefit, and thus can contribute significantly more each year. Typically, the older an owner is, the higher the resulting maximum contribution tends to be.

What types of businesses use defined benefit plans? Professional service firms, law firms and physician groups are ideal candidates. Independent consultants, manufacturers' reps, multilevel marketers and realtors are also well suited, but virtually any privately held business with excess earnings might benefit. Supplemental income from speaking engagements, book sales, consulting or director's fees can often be earmarked almost entirely for plan contributions.

Defined benefit plans have actually been around for decades, but they generally required an actuary or other pension consultant to be directly involved in the set up. The process was complicated, the timetable was long, and the plan design and maintenance was often quite costly.

Tax law changes in the late 1990s, along with new technology, have combined to change all that. Business owners can now set up plans directly through their own tax or financial advisors entirely online or by calling a customer support number and joining a web cast directed by a qualified plan specialist. A sole proprietor can be set up with a plan in a matter of minutes, and a business with multiple owners and employees can often get set up in just a few hours. These types of plans are generally simple and easy to understand, they're quick to set up, and consequently, they're less expensive to the end consumer.

Defined benefit plans do come with some considerations, however. First, like all qualified plans, including 401(k) plans, owners must provide a certain level of benefits to their employees. While today's defined benefit plans are generally designed to vary contribution levels among owners to meet different financial objectives, employees need to be provided with an acceptable level of benefits to meet strict IRS nondiscrimination requirements. The good news is, they can be combined with an existing 401(k) or profit-sharing plan, which results in total employee costs of around 6 to 8 percent of their annual salary.

Second, owners must intend to fund the plan at some meaningful level for at least the next five years. This is an inexact IRS stipulation designed to ensure that pension plans contain some degree of "permanency." Exceptions are available for "business reasons," such as the sale of the business or the retirement of the key person.

Finally, unlike a SEP or 401(k) plan, contributions to a defined benefit plan aren't purely discretionary. Instead, owners are expected to contribute a set amount or a percentage of income each year. If circumstances change and business owners need to alter their contribution structure, they can always amend their plan document.

So what happens when an owner retires? Typically, the plan is terminated and distributions from the plan are rolled over into an IRA. Withdrawals from the IRA are then set to meet the retiree's preference, subject to applicable restrictions.

If you're curious about just how much you can contribute to a defined benefit plan each year, this calculator will help you determine just how much of your income you can defer to the plan.