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Employee Benefits
Business Owners: Quadruple Retirement Plan Deductions with Defined Benefit Plans
By J. Patrick Costello
Investment Advisor Representative, Equity Services, Inc.
It is no secret that successful professionals and business owners would do well to maximize their deductible retirement plan contributions. Unfortunately, many business owners are only aware of SEP IRAs and 401(k)/Profit Sharing plans. These types of retirement plans are fine, as far as they go, but they both have maximum annual deductible limits of less than $50,000. How much impact will a $50,000 deduction have on a business owner’s or professional’s tax bill, if he or she is earning $500,000 or $1,000,000 a year? The answer is…..not much!
Fortunately there is another option: the Defined Benefit plan. A DB plan permits annual deductible contributions of $350,000 dollars or more. Are they new? No – they’ve been around for decades. They are essentially the small company version of the pensions offered by large corporations and governments to their employees. As the name implies, a DB plan is designed, using actuarial assumptions, to deliver a specific benefit – namely a lifetime pension – beginning at a certain retirement age. But don’t worry about losing control of your money – many people simply rollover their accumulated DB plan assets into an IRA at retirement, and never actually convert the accumulation amount (lump sum) to a pension.
The beauty of the DB plan for small, closely held businesses is that you – the owner of the company – decide how big a (theoretical) pension you wish to fund, based on the size of the deduction you are currently seeking. For example, based on your salary history, age, and time left before projected retirement, you may qualify for the maximum permissible 2006 pension benefit: $175,000 per year. After applying the IRS’ actuarial formula, this translates to a maximum current deduction of $300,000. However, you may only be seeking a $200,000 deduction this year. Not a problem: you simply have your DB plan administrator adjust the plan formula for the pension benefit that equates to a current deduction of $200,000. If your business is more profitable next year, you may be able to amend your plan for a higher deductible contribution – it’s up to you and your pension administrator.
What are the other ways that these plans differ from SEP IRAs and 401(k)/Profit Sharing plans? One significant difference is that you must meet a “permanence” test – the plan cannot be for the purpose of sheltering a single year “windfall” influx of taxable income. Most retirement plan administrators feel that level funding of a DB plan for at least three years meets the “permanence” test. Like other types of retirement plans, DB plans can be used by sole proprietors as well as S Corps and LLCs.
DB plans can also be designed to include an insurance component that in effect guarantees a certain benefit to the participant’s beneficiary should he or she die before retirement.
What about employee costs? Just as with other conventional retirement plans, full time non-unionized W2 employees may be eligible for a contribution from the company. There are intricate rules governing the eligibility of employees. Some employees may be excluded from your DB plan under the tax code, particularly if they fall into the “highly compensated” category.
The moral of the story is that if you are a business owner, interested in dramatically increasing the amount you are able to deduct and contribute to the company or firm retirement plan, find an experienced, independent financial planner who will provide you with a preliminary assessment of your Defined Benefit plan opportunities. You may be able to drastically reduce your quarterly estimated taxes and redirect a significant portion of those dollars to your own retirement plan.
Securities and investment advisory services offered solely by Equity Services, Inc., Member NASD/SIPC. Costello and Associates is independent of Equity Services, Inc.
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