If the normal plan limits for a simple Individual Retirement Account, SEP/profit sharing or individual 401(k) are too low, the defined-benefit plan offers an option to contribute significantly more than the $55,500 limit for an individual 401(k).
These Internal Revenue Service-approved qualified retirement plans allow small-business owners, consultants or any person with significant self-employment income to make large annual contributions and accumulate as much as $1 million to $2 million in a five- to 10-year period. The contributions are deductible and potentially can reduce income tax liability by $30,000 to $40,000 or more annually.
When you set up a defined-benefit plan, it promises a specific annual benefit in retirement. The annual benefit is a function of what percentage of compensation one can realistically contribute to the plan on an annual basis. The maximum annual benefit is $200,000 based on current regulations. Each year, the business owner is required to contribute an amount that is sufficient to pay the annual benefit in the future based on actuarial assumptions used by the plan administrator. The annual contribution is based on a variety of factors such as current age, compensation and planned retirement age.
In general, the older the business owner is, he or she will have to contribute larger annual amounts because there are fewer years to contribute and accumulate enough to pay out the specific benefit.
The larger contributions most likely will result in larger deductions on the tax return. Depending on the business structure, the type of eligible compensation used to calculate the annual contribution can differ. In most cases the planned retirement age is usually five years or more from when the plan is adopted. Finally, the assets in the plan can be invested in mutual funds, bonds, equities and other marketable securities. The strategy should be tilted toward low volatility to ensure consistent contributions.
Defined-benefit plans are best suited for individuals with self-employment income or small-business owners who are 40 and older, interested in contributing more than $50,000 for at least three to five years and earning at least $100,000 from self-employment income.
Self-employment income can be a result of the following types of situations, in which a person:
• Owns a business with five or fewer permanent employees including the owner.
• Is self employed as a primary means of earning a living.
• Has a second occupation in which he or she works for himself or herself.
• Is considered an independent contractor rather than en employee.
• Receives payments or royalties from patents, books, consulting, board-of-directors fees or speaking engagements.
Here are a few examples:
Dr. Charles, 52, is a radiologist who expects to have an annual W-2 Income of at least $450,000 from his medical practice until he retires in 10 years. He establishes a defined benefit plan to increase his retirement savings and reduce his tax liability. In addition, he also can contribute to a 401(k) to increase his tax savings.
Here is how it works for the radiologist:
• Annual defined-benefit plan contribution: $161,700.
• Annual defined-benefit tax deduction: $161,700.
• Annual contribution to 401(k): $37,500.
• Annual tax savings at 35 percent: $69,720.
• Projected accumulation in 10 years: $2.42 million. That assumes 10 years of funding, 5 percent to 7 percent return for the defined-benefit plan only, and excludes contribution to 401(k), which can be optional.
• Annual retirement benefit: $200,000.
Claire, 48, a software engineer, has a C-Corp but wants flexibility in her contribution amounts. She has W-2 earnings of $135,000 but is not sure she can maintain the high contributions each year. In this case, Claire can also contribute to a 401(k) to increase her tax savings but this portion is optional each year.
Here is how it works for the software engineer:
• Annual defined-benefit plan contribution: $63,900.
• Annual defined-benefit tax deduction: $63,900.
• Annual contribution to 401(k): $25,100.
• Annual tax savings at 35 percent: $31,150.
• Projected accumulation in 10 years: $1.63 million. That assumes 14 years of funding, 5 percent to 7 percent return for the defined-benefit plan only, and excludes contribution to 401(k), which can be optional.
• Annual retirement benefit: $135,000.
Legislation provides some flexibility for defined-benefit plans but contributions are required to stay on track to deliver the promised benefit. When the plan is terminated, the assets can be rolled to an IRA, where they can continue to grow, tax deferred, until they are withdrawn. Finally, plans must be opened by the end of the business fiscal year, generally, Dec. 31.
Robert J. Pyle, CFP, CFA, is president of Boulder-based Diversified Asset Management Inc., an investment adviser registered with the state of Colorado. This column reflects the writer’s views and is not a recommendation to buy or sell any investment. It does not constitute investment advice. Contact Pyle at 303-440-2906 or firstname.lastname@example.org.