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Self Employed Retirement Plan Basics
By Jason Watson, CPA
Posted Wednesday, October 13, 2021
There are two plan basics, either a defined contribution plan or a defined benefits plan.
A defined benefit plan is a benefit that is payable to you upon retirement. It is usually based on formulas to compute the periodic payments made to you during retirement. These are sometimes referred to as a pension or annuity since a benefit is defined, and the paid to you. For example, military personnel who meet certain obligations are paid a recurring benefit for the rest of their lives. It might be indexed each year for cost of living increases and it might have survivor benefits. Either way it is a guaranteed payment based on a formula. If you live to 100, you might “beat the system.” If you die at 55, the pension payment ends and the money set aside for you is lost.
In contrast, a defined contribution plan specifies how much money will be contributed to a retirement plan today. This is precisely how 401k plans work. It removes a lot of the guesswork and risk from guaranteeing a certain defined benefit to you upon retirement. Rather, the risk is all yours- the amount you invest, how long you invest and how you invest it will dictate the retirement benefit. This benefit might be projected with planning software, but it is not technically defined or guaranteed.
Because of guaranteed payments and life expectancy issues, employers have scaled back on defined benefit plans. The cool thing is this- as a small business owner you are the employer and defined benefit plans might have a real place in your retirement planning. One of the examples is a cash balance account which is technically a defined benefits plan, but you can see the account balance like a defined contribution plan. More on that later.
Some terminology clarification. We use the word deferral when referencing employees and contributions when referencing businesses. When an employee is putting money into a retirement plan, he or she is deferring a portion of compensation hence our use of deferral. This has nothing to do with deferring taxes since deferrals into Roth 401k plans do not reduce taxes.
As a side bar deferred compensation plans include pension plans, retirement plans and employee stock option plans. For now, let’s go back to the defined contribution plan and run through some of the basics.
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