Saving for retirement when you’re self-employed can feel overwhelming. It’s tough to know which savings options are best for your unique situation. One option worth exploring is a pension for your small business (even if you’re the only employee).
Pensions are ideal retirement savings vehicles for several reasons. They provide protection from market ups and downs, they provide a consistent income during retirement, and they make retirement budgeting easier – because you’ll always know how much money you’ll receive from your pension benefit each month.
Additionally, pensions have several benefit options that you can elect when you retire:
- Lump sum
- Single life
- 50% joint and survivor
- 100% joint and survivor
- Life with 10 years certain
These different election options give you flexibility to provide retirement income for both you and, potentially, for your spouse during retirement.
This set-up is different from a traditional 401(k), or other retirement savings accounts. Defined contribution plans give you the option to save for retirement, but converting that savings into an ongoing monthly retirement income is entirely up to you when you retire. A pension, on the other hand, provides a consistent monthly benefit throughout your retirement, and your business pays into it rather than you having to contribute.
What Types of Pensions Are Available?
Defined benefit plans work just as a traditional pension at a larger corporation would. The business makes contributions for all eligible employees, and the employee pensions “vest” over the course of their employment. You can enroll in the defined benefit plan, and your employees can participate as well.
Contributions are tax-deductible for the business, and the benefits are taxed when they’re distributed to employees during retirement. However, unlike a defined contribution plan, contribution limits are much higher in traditional defined benefit plans as they are geared towards funding a stream of income and not just saving each year. You could potentially put upwards of $225,000/year (in 2019) into your defined benefit plan.
Additional Option to Consider: Cash Balance Pensions
It’s worth mentioning that you can also look into a cash balance pension for your business. They offer defined benefits to your business’s employees (even if that’s just you), but they show the balance in your pension as a “cash balance” like a 401(k) would, rather than a consistent monthly benefit.
A cash balance plan tends to be appealing to a younger employee because of the way their benefits are calculated. Traditional pensions calculate your benefits based on how much you’ve earned over the course of your career with a company, and how long you’ve worked there. Cash balance plans don’t follow this same calculation. Instead, they grow at a relatively even rate over the course of your career – so any contributions made during younger years have more time to accumulate interest.
This is a fair option to consider, but because they don’t necessarily provide consistent monthly income, they may not be what you’re looking for. That being said, cash balance pension plans have a much higher contribution limit than even traditional defined benefit plans. Individuals who are older than 60 could potentially save over $261,000 each year.
Common Pension Misconceptions
When sitting down to speak with Nora Bethman, CEBS, QKA, ERPA, of National Employee Benefit Services, Inc. she mentioned that there are two consistent misconceptions that business owners make when considering a defined benefit plan for their business:
Misconception #1: Defined benefit plans are always the best option for business owners who want consistent income during retirement.
Defined benefit plans aren’t always in a business owner’s best interest. Their hefty required contributions can really put a dent in cash flow, and if you have a small business with several employees, they can get very expensive. 401(k)’s or other defined contribution plans have more flexibility – you’re able to contribute when you have the cash flow, and you’re not obligated to fund them each year.
However, defined benefit plans can be a good move for a business owner who is nearing retirement, and has the cash flow to support their contribution requirements. This is especially true if they’re self-employed and don’t have any additional employees. They can maximize a pension for their own use without worrying about the added expense of employees who would have to participate in their plan.
Misconception #2: Cash balance plans are best because they have such a big contribution limit and deduction availability.
According to Nora, cash balance plans are very popular right now because they’re a relatively new concept. But that doesn’t mean they’re your best bet when it comes to retirement planning. In fact, if you’re a relatively young business owner who is dealing with other financial problems (like student debt), your priorities may need to shift year-to-year.
Unfortunately, a lot of individuals who claim to be “financial planners” receive large commissions for selling cash balance plans – even if it isn’t right for the individual. This is where speaking with a consultant like Nora, or like myself, can help you get advice that’s always going to be in your best interest.
What’s Best For You?
It’s tough to know which pension plan is best for you as a self-employed individual. Generally speaking, having a pension option as well as another retirement savings vehicle – like an IRA or a 401(k) – can help you to diversify your savings and boost your overall yearly savings as you move toward retirement. If you have questions about how to find the best pension choice for you, contact me today. I’d love to walk you through your options.