Capacity Unused

The default, and its ceiling

Most independent professionals arrive at a SEP or a solo 401(k), because those are what a preparer can set up quickly and what most articles describe. Both are defined contribution arrangements, and defined contribution plans share a common feature: an annual additions limit that applies regardless of how much you earn.

At $2m of income that ceiling is reached long before your capacity to save is. The plan is not wrong; it is simply the smallest of the available options, and for many people it is the only one they were ever shown.

The defined benefit alternative

A defined benefit plan works from the opposite direction. Rather than limiting what goes in, it defines a benefit payable at retirement and works backwards to what must be contributed each year to fund it. The contribution is an actuarial output, not a fixed cap.

Two variables drive it. The benefit being funded, and the number of years remaining to fund it. Which produces the defining characteristic of this structure: the older you are, the larger the deductible contribution, because there is less time to accumulate the same benefit.

A cash balance plan is a defined benefit plan expressed as a hypothetical account balance, which most people find easier to understand and which is frequently the practical form this takes.

What it actually requires

This is not a form you complete. It is a plan with ongoing obligations, and it should be entered knowing them.

• An actuary, annually. The contribution is calculated, certified, and filed.
• A funding commitment. This is the substantive difference from a SEP. The contribution is not discretionary year to year, and a business with volatile income needs the plan designed around that volatility rather than against it.
• Employees must generally be covered. If you have staff, the plan has to work for them too, and that changes the arithmetic considerably.
• Administration and filings, which carry real annual cost. Worthwhile at this level of contribution, and not at lower ones.
• A plan document adopted by a deadline. Miss the year and the capacity for that year is gone.

Why it goes unused

Not because it is obscure. Because it requires a conversation somebody has to initiate, in a year when the person who would benefit is busy having the year that makes it worthwhile.

And because contribution capacity does not carry forward. Every year it goes unused is simply gone, which is an unusually clean example of a cost that never appears on any statement.

Where this lands

1. 01Establish what you are contributing now and what the ceiling of your current arrangement is. Many people discover they are well under even that.
2. 02Have a defined benefit design run if your income is durable, you are past your mid-forties, and your headcount is low. It costs an actuary's fee to find out.
3. 03Model the funding commitment against a bad year, not a good one. This is the honest test of whether the structure suits you.
4. 04Act before the adoption deadline for the year you want to cover. This is a hard date and the capacity does not wait.