Latest / The High Net Worth Podcast with Fexingo: Wealth Management, Tax Strategy, and Affluent Finance / How Ultra-Wealthy Families Use Defined Benefit Plans
Transcript
- Lucas: So we've talked a lot on this show about trusts, about captive insurance, about all these exotic structures that wealthy families use. But there's one tool that's been around for decades, sits right under their noses, and I think we haven't given it nearly enough airtime. I'm talking about defined benefit plans. Not the corporate pension your grandfather might have had, but the modern, cash balance version that a 55-year-old founder can use to stuff three hundred thousand dollars a year into a tax-deferred account. Luna: Wait, three hundred thousand? That's way beyond the regular 401k limits. How does that work without tripping every IRS rule in the book? Lucas: Right, and that's exactly the question. The key is that a defined benefit plan promises a specific retirement income, not a contribution amount. So the annual contribution is whatever the actuary says is needed to fund that promised benefit. And for a 55-year-old, that can be a massive number. Think about it: you have maybe ten to fifteen years to accumulate enough to pay out, say, two hundred thousand a year starting at sixty-five. The math gets aggressive. Luna: So it's not about saving a fixed percentage like a 401k. It's about hitting a target. And the older you are, the bigger the annual contribution gets, because you have less time to compound. Lucas: Exactly. In fact, the IRS publishes these maximum benefit limits, and they're adjusted for inflation. For 2026, the annual benefit limit is around two hundred eighty thousand dollars. And the contribution limit is essentially the actuarial present value of that benefit. For a 60-year-old, that can translate into a contribution north of three hundred fifty thousand dollars in a single year. That's a massive tax deduction, often at the highest marginal rates. Luna: But isn't that just for C-corps? I've heard defined benefit plans are a headache for small business owners. Lucas: It works for sole proprietors, partnerships, LLCs, S-corps — any business with net earnings. But you're right, there's complexity. You need an actuary to certify the funding level every year, you need annual filings, and you have to follow a strict funding schedule. It's not a set-it-and-forget-it like a SEP or a solo 401k. But for someone who's maxed out those, it's a serious step up. Luna: So the tradeoff is administrative hassle for a massive deduction. Let's get into a concrete example. Lucas: Let's do it. Take a 55-year-old consultant, let's call her Sarah. She runs a solo practice and nets about eight hundred thousand a year. She's been maxing her solo 401k, that's sixty-nine thousand in 2026 including the employer contribution. But she wants to save more, tax-deferred. She sets up a cash balance plan, which is a type of defined benefit plan, and her actuary calculates that to fund a benefit of one hundred fifty thousand a year at sixty-five, she can contribute about two hundred thirty thousand this year. That's on top of the sixty-nine thousand. She just cut her taxable income by nearly three hundred grand. Luna: That's a huge deduction. But what does she get on the back end? Is it guaranteed? Lucas: The plan promises a benefit. The assets are held in a trust, typically invested in a conservative mix, and the plan is insured by the PBGC up to certain limits. So there's some security. But here's the kicker: if she overfunds the plan, meaning the assets grow faster than expected, she could face penalties and excise taxes. That's the risk. You can't just let it ride like an IRA. Luna: So there's a reward for conservative investing. That's interesting. But what if she wants to retire early? Does that mess things up? Lucas: It can. If she retires at fifty-eight, the actuary needs to recalculate. The benefit might be lower, and the contributions she made might be more than needed. That could trigger a reversion of excess assets, which is taxable and subject to a twenty percent penalty. So it's a commitment. You're really locking yourself into a retirement age and a benefit level. Luna: So this is not for someone who's unsure about their future. It's for someone with predictable income and a clear retirement horizon. Lucas: Exactly. And that's why it's often perfect for a family business where the founder wants to retire at a certain age and maybe bring in the kids. You can even design the plan to cover employees, which adds cost, but for a solo practice, it's just you. Luna: Let's talk about the cost. What are we looking at in terms of setup and annual fees? Lucas: Setup can be anywhere from two thousand to ten thousand dollars, depending on complexity. Annual actuarial and administrative fees typically run between two and five thousand. Plus, you need a third-party administrator. So it's not cheap, but when you're deferring two hundred thirty thousand a year, the tax savings dwarf those costs. Luna: Totally. That's a no-brainer for Sarah. But I'm wondering about the investment side. Is the money locked up until sixty-five? Or can she access it earlier? Lucas: There are some limited loan provisions, but generally, withdrawals before age fifty-nine and a half trigger a ten percent penalty, same as an IRA. And the plan document has to specify the distribution options. But here's the estate planning angle: if she dies before retirement, the death benefit can be substantial, and it can be structured to provide income to a spouse or heirs. That's a nice feature. Luna: So it's not just a retirement plan, it's also a death benefit vehicle. That's smart for the family. But what if the business has a bad year? Can she skip a contribution? Lucas: You can't just skip. The funding requirement is based on the plan's funded status. If you miss a required contribution, you could face a funding deficiency penalty. However, you can amend the plan to reduce future benefits, which lowers the required contribution. So there's flexibility, but it requires proactive management. You can't just ignore it. Luna: So you'd need a good actuary and a good financial advisor. This is not a DIY thing. Lucas: Absolutely not. And that's a barrier for some people. But for the ultra-wealthy, the complexity is a feature, not a bug. It's another tool in the tax planning toolkit. And let's not forget that the contributions are made pre-tax, so they reduce your adjusted gross income, which can also lower your Medicare premiums and potentially keep you under the net investment income tax threshold. Luna: Oh, that's a good point. It's not just the income tax deduction. It has ripple effects on other taxes. Lucas: Right. And for families, you can set up a plan that covers multiple family members, maybe a spouse who works in the business, or even adult children. Each participant gets their own benefit accrual, and the actuarial funding accounts for that. So a husband and wife, both employed, could potentially double the contribution limits. Luna: But wait, with the husband and wife both covered, doesn't that create issues with the discrimination testing? The plan can't favor highly compensated employees. Lucas: Right, the IRS requires that the plan not discriminate in favor of highly compensated employees. So if you have regular employees, you'd have to include them, which raises the cost. That's why this is often used in businesses with no employees besides the owner and family. If you're a solo doctor, or a consultant, it's perfect. If you have fifty staff members, it's a different story. Luna: So the sweet spot is a business with minimal staff. Let's talk about a real-world scenario. I've heard of a family where the father is a surgeon, the mother runs the practice, and they have two teenage kids who do part-time work. Can they set up a plan that covers the whole family? Lucas: You can, but the kids would only get a small benefit accrual based on their compensation. The parent's contributions would be the bulk. But it does allow you to shift some income into the kids' future, and since they're in a lower tax bracket, that might be a long-term benefit. That's more of an estate planning angle. Luna: Got it. So for the high earner with a couple of family members on payroll, it's a powerful tool. But there's also a catch, isn't there? What happens if you decide to shut down the plan? Like, you retire, or you just don't want the hassle anymore. Lucas: When you terminate the plan, you have to distribute the assets to participants. If it's well-funded, you can roll the money into an IRA, which preserves the tax deferral. But if it's overfunded, the excess above the promised benefit reverts to the employer and is taxable as income, plus a twenty percent penalty. So you want to avoid that. That's why it's important to work with an actuary to keep the funding roughly in line with the benefit. Luna: So it's a long-term commitment, but when structured right, it's a phenomenal way to build retirement wealth. I'm curious, Lucas, is this something you've seen used often in your experience? Lucas: It's become more popular in the last decade as the solo 401k and SEP limits have stayed relatively low while the defined benefit maximums have grown. For a high earner, it's one of the last big tax shelters. And with the current rate environment, it's even more attractive. Actually, you know what, we've been talking about a lot of advanced strategies on this show. And if you're finding these conversations useful, there's a simple way to keep them coming. A small group of listeners already chips in monthly through buy me a coffee dot com slash fexingo. That's what keeps this podcast ad-free and independent. So if you're able, that's the place to support. Luna: Yeah, and it's not about perks or rewards. It's just about keeping this kind of deep-dive available to everyone who wants it. And honestly, every contribution, no matter how small, makes a real difference. Lucas: And we're grateful for that. But let's get back to Sarah. We talked about her, and she's set up her cash balance plan. She's making these huge contributions. But what about the other side of the coin? What if the market tanks and the plan's investments drop? That doesn't change her benefit, right? Luna: Right, the benefit is defined, not the contribution. So if investments underperform, the employer might need to make additional contributions to make up the shortfall. That could be a burden on the business. Lucas: Exactly. That's the risk. With a defined contribution plan like a 401k, the employee bears the investment risk. With a defined benefit plan, the employer bears the risk. That's why conservative investments are key. You don't want to be forced to write a big check to the plan in a down year when your business might also be struggling. Luna: So it's a tradeoff: you get a guaranteed benefit, but you also take on the funding risk. That's why it's not for everyone. But for a doctor with a steady practice, it's a strategic advantage. Lucas: And let's not forget the asset protection angle. In many states, qualified retirement plan assets are protected from creditors. So if Sarah gets sued, her retirement assets are generally safe. That's a nice bonus. Luna: Oh, that's a significant point. So it's not just about tax deferral; it's also about shielding wealth. That could be a deciding factor for a professional with high malpractice risk. Lucas: Sure. A surgeon, a lawyer, an architect — anyone with liability exposure. The plan assets sit in a trust, and federal law protects them from most judgments. That's a powerful reason to use this structure beyond the tax savings. Luna: So for Sarah, the plan does triple duty: tax deduction, retirement income, and asset protection. Not bad. Lucas: And it can be part of a larger wealth transfer strategy. She could name her children as beneficiaries, and they'd receive the benefits as designated beneficiaries, potentially stretching the distributions over their lifetimes. That's a way to pass wealth without estate taxes. Luna: So it fits into the whole estate planning puzzle. I'm starting to see why this is such a popular tool for the ultra-wealthy. Lucas: And if you're a business owner thinking about succession, you can sponsor a defined benefit plan that also covers your successor, or even a key employee. But again, that increases the cost. So it's usually most efficient when it's just the owner and maybe a spouse. Luna: What about a young business owner, say thirty-five? Is it still worthwhile? Lucas: The annual contribution limit is much lower because you have more years to compound. For a thirty-five-year-old, the maximum might be around forty or fifty thousand a year. That's still useful, but the real power comes when you're in your fifties and you have fewer years to go. That's when you can make these massive contributions. Luna: So it's a late-career strategy. Makes sense. And with the clock ticking, those big contributions can really boost retirement savings. Lucas: Exactly. And that's the beauty of it. The system rewards those who plan ahead and use the rules to their advantage. Defined benefit plans are one of the last big tax-deferred vehicles for high earners, and they're underused. Luna: Underused, but not exactly beginner territory. I'm glad we could demystify it a bit. So if someone's listening and thinking, 'This could work for me,' what's the first step? Lucas: Talk to a qualified retirement plan consultant or actuary. They can run the numbers and see if it makes sense for your situation. You'll need to project your retirement income needs and your expected retirement age. And be ready to commit to the administrative side. It's not for the faint of heart, but for the right person, it's a game-changer. Luna: And maybe that's the takeaway: it's not the most glamorous tool, but it's one of the most effective. Thanks for the deep dive, Lucas. Lucas: Anytime. And if you're curious about how this fits with other strategies we've covered, like family limited partnerships or grantor retained annuity trusts, they can work together. But that's a conversation for another day.