Minimizing taxes isn’t always the best idea. Rich found this out the hard way.

You may have heard the tax advice, “Don’t spend a dollar to save 30 cents.” Rich, the owner of an outdoor recreational vehicle store in Berkshire County, fell prey to that tactic.

Rich would brag about how he never had to pay taxes. How did Rich achieve this? He would buy inventory (stuff that he probably wasn’t going to sell soon), buy a company truck (that Rich didn’t need), or upgrade computers and other equipment (although what he had was perfectly fine). I burst poor Rich’s bubble; I asked, “So your business doesn’t make any money?”

“What, no!” Rich exclaimed. “I just spend all the profits.”

“Yeah, Rich,” I explained. “That’s the definition of not making any money.”

Still, I get where Rich was coming from. Generally, we hate to pay more taxes than we should. However, not all tax savings tactics are created equally. What if I told you that instead of spending that dollar to save 30 cents, you could invest it in a way that maximizes your retirement? What if you could go one step further and use that same plan to attract and retain talent in this tight labor market?

A defined benefit (DB) plan can be a game-changer for small business owners looking to reduce tax liabilities. This type of retirement plan, often overlooked in favor of defined contribution plans like 401(k)s, offers significant tax advantages and allows for substantial retirement savings.

The basics of a defined benefit plan

A DB plan guarantees a specific lump sum at retirement, typically based on factors like salary, age, and years of service. Unlike a 401(k), where contributions are capped at $30,500 annually for those aged 50 or older (in 2024), DB plans allow much higher contributions. Depending on the owner’s age and income, the 2024 contribution limits can be as high as $275,000 annually (or 100 percent of the participant’s average compensation for their highest three consecutive calendar years).

A DB plan can reduce the business’s taxable income and create a nest egg for retirement. Contributions are calculated based on the benefits promised to participants, meaning the owner’s contributions can be disproportionately large compared to those of employees.

How defined benefit plans reduce tax bills for small businesses

For small-business owners with high incomes, DB plans offer one of the most effective ways to reduce the company’s tax obligation. Here’s how:

1. Avoid taxes: Contributions are fully tax-deductible to the business.
2. High contribution limits: Due to their age and higher salaries, owners, especially those nearing retirement, can make substantial contributions.
3. Offset employee costs: While contributions must be made for eligible employees, the overall tax savings can offset the cost. Additionally, employee contributions are tax-deductible to the company, further enhancing the plan’s appeal.
4. Avoid payroll taxes: Contributions to the DB plan are not subject to payroll taxes, which can provide additional savings compared to paying bonuses or higher salaries to employees.
5. Deferral of taxes: Contributions grow tax-deferred until withdrawal, allowing the owner’s retirement funds to compound.

Designing a defined benefit plan for maximum tax avoidance

The key to maximizing the tax advantages of a DB plan lies in its design. An adviser can tailor the plan to the owner’s unique circumstances to determine the estimated lump sum size at the time of their retirement (aka, the “defined benefit.”) For example:

• Age-weighted contributions: Older employees closer to retirement, like the business owner, receive larger contributions due to their shorter time to retirement.
• Minimum participation requirements: Setting minimum service or age requirements can limit eligibility to long-term employees, reducing the overall cost of funding the plan.
• Paired plans: A DB plan can be paired with a 401(k) or profit-sharing plan to provide flexibility and meet the needs of a larger workforce.

Mary is a 55-year-old owner of a multimedia marketing agency in Westfield. Mary pays herself a $300,000 salary. The plan determined that Mary required a $200,000 annual contribution to meet her retirement goals. That $200,000 investment into her DB plan reduced the company’s tax obligation by about $70,000 annually (based on a 35 percent tax rate).

While the business owner must make contributions for employees, that benefit does not need to mirror the owner’s percentage of income. The actual amounts depend on the plan’s design, actuarial calculations, and compliance with nondiscrimination rules.

Mary’s employee, Janet, is 35 and has worked with the company for enough years to meet the minimum participation requirement. Janet earns $50,000 annually. Because of Janet’s lower salary and extended retirement time, the DB plan calculates that Janet requires a $100,000 annual contribution, which reduces the company’s tax obligation by about $3,500.

Mary’s high income made the DB plan ideal for her business. She achieved immediate tax reduction and long-term wealth accumulation and used the plan to enhance employee satisfaction relatively cheaply.

The negatives of a defined benefit plan

• The cost of a DB plan with 50 or more employees could outweigh the tax advantages for the company. (A simple IRA plan may be more appropriate for larger companies.)
• It takes work to do it yourself. A company with 20 to 50 employees should work closely with an advisor to balance costs and benefits. (Paring a DB plan with a defined contribution plan, such as 401(k), can be a good compromise.)
• Best suited for highly compensated professionals aged 50 or over who can make annual contributions of $90,000 or more for five to 10 years.
• Required minimum distribution withdrawals must begin by age 73, even if you are still working.

A defined benefit plan offers small-business owners a unique opportunity to reduce taxes, build significant retirement savings, and attract and retain employees.

This article first appeared in the Berkshire Eagle on December 7, 2024.