Hey there, high earning small business owner! As your marathon of a working career edges ever closer to the finish line of financial independence and/or retirement, you may be looking for a few more ways to fund your nest egg. Or you may need to help neutralize the negative effects tax drag is wreaking on your ever-increasing income as an entrepreneurial business maven.
Sure, having a high income is a great problem to have, but by no means does it automatically ensure an easy ride financially, nor does it mean you are on the path to financial independence. Consequently, tax-deferred strategies via self-funded pension plans may offer some real value, and you give your retirement readiness a nice boost. (For related reading, see: IRS Rule on 401(k) After-Tax Dollars)
A few of you reading this may be lucky enough to still have a pension through your employer. But the days of working for decades with one company with fabulous benefit packagee–you put in your time, then are guaranteed an income throughout retirement–are gone for most rank and file workers. Today, those who work in the private sector or who are self-employed can expect little to none of these benefits in their golden years.
Defined Benefit Plan to Help Fill the Retirement Savings Gap
But there is a program structured for small business owners–that is, those with just a few employees or who work as sole proprietors–generally in their 50’s, who want to sock away more for retirement and are looking to reduce their tax bills. It’s specifically for folks who earn high enough incomes to afford to put much more away than is allowed with just a 401(k) plan. This kind of advanced financial planning tool is called a Defined Benefit Plan.
One type is known as a Cash Balance Plan. Employers can deduct their contributions, resulting in large tax deferrals, all the while creating their own “personal” pensions. Much like the pension plans our parents or grandparents enjoyed, these will guarantee a set monthly payment in retirement through the rest of your life. This is assuming you make the appropriate contributions to the plan. Remember not all plans are created equal, guarantees are based on the ability of the company to pay claims. (For more, see: Pension Options: Payout vs. Payments)
Defined benefit plan contributions are mostly based a combination of your age and income. The younger you are the smaller the contributions, as the money has more time to grow. But you may be able to contribute north of $200,000 per year for yourself. This is potentially above and beyond what you can put into a 401(k) profit sharing plan. In fact, to maximize potential contributions and to lower you tax bill in the current year, and get tax deferral for the savings, your financial planner can structure these two plans together for you.
As with any retirement plans there are pros and cons. Let’s take a look.
Ideal Candidate for a Defined Benefit Plan
Cash balance or defined benefit plans are best suited for small-business owners (including the self-employed) who face high tax bills, and want to put away more money in a tax-deferred manner. For most defined benefit plans I’ve set up over the years, lowering tax bills now has been the main objective, with financial security and saving for retirement coming in a close second. Ideally you would have the desire or ability to put away $100,000 or more for the next five to 10 years between your 401(k) and a defined benefit plan. (For more, see: 4 Mistakes to Avoid with Your Retirement Plan)
CASE STUDY: The Saver
The business–let’s call it Really Smart Partners for discretion purposes–last year was getting killed on taxes as its income was expected to keep growing by leaps and bounds. The 401(k) profit sharing plan was modified and a new defined benefit cash balance plan was established to maximize the contributions the business owner was allowed to make into both. (Bigger contribution, bigger tax deferral) In this case, he already had several years of the maximum contributions saved in a taxable account. So even if business dropped off dramatically, he could still use that account to fully fund the plan over the next few years. That big tax now? Say hello to literally over $100,000 per year in additional potential tax-deferred contributions.
CASE STUDY: The Sprinter
For other business owners, the defined benefit plan can be more of a sprint if established in the last few years leading up to retirement. They need to put away large amounts of money if they want any chance of maintaining their standard of living after they retire. But the huge tax benefits and deferrals with cash balance plans make it much easier to put even more money away. Which also makes it easier to get on track for retirement.
Defined Benefit Plan Drawbacks
Opening and maintaining a defined benefit plan is more complicated than opening a basic IRA, or even maintaining a profit sharing plan. There will be a few IRS hoops to jump through to set up and fund the plan. As with so many things in life (sigh), bigger benefits may come with some bigger headaches.
And don’t be dazzled by the dream of guaranteed lifetime income or a huge tax deferral. Alas, some of the best things in life are definitely not free. To obtain these things you actually have to contribute money, and often quite large amounts of money up front. Furthermore, you will need to fund your plan consistently at a hefty minimum level each year. Even if business drops off, you will still be required to keep up your contribution. Plan can be reworked, but that can be costly and options are specifically limited. To stay compliant with IRS rules, you will also generally need to keep the plan in place for at least five years. And you will have to work with an actuary to do all the fun actuarial things that go into calculating and analyzing the plan.
Like your pensions, IRAs or 401(k)s, distributions from defined benefit plans will be taxed as ordinary income. To reiterate again, these plan work best for people who can commit to at least five years of contributions. There are IRS penalties for taking money out prior to age 59½, and further early distribution may put the viability of the plan in jeopardy. (For more, see: What to Do to Prepare for Retirement)
If you are behind on saving for retirement–and trust me, many people are woefully behind in a fog of denial and credit card debt–don’t feel bad as long as you take action now to get your financial house in order. As a small business owner who earns a good income but is starting late, maxing out an IRA is not going to cut it, and even maxing out a profit-sharing 401(k) with contributions above $50,000 may not really be enough to maintain your standard of living in your golden years.
By the time they come to me to as a fiduciary financial planner to discuss if a defined benefit plan is right for them, most people have already explored or maximized the other easier and more flexible options before setting up a personal pension via the cash balance plan. So for them, it’s well worth investing the money, time and effort. A good talk with your trusted fiduciary CFP™ working with your CPA should be able to help you figure out if this vehicle is the right option for you. More importantly, it will help you figure out how to maximize the benefits of the plan for your specific financial wants, need, dream and goals.
Until next time and as always, Be Fiscally Fabulous, and remember Your Money Matters.
Securities and advisory services offered through National Planning Corporation (NPC), Member FINRA/SIPC, a Registered Investment Adviser. Additional advisory services offered through Trilogy Capital, a Registered Investment Adviser. Trilogy Capital, Trilogy Financial and NPC are separate and unrelated companies. The opinions voiced in this article are for general information only. They are not intended to provide specific advice or recommendations for any individual and do not constitute an endorsement by NPC. NPC does not render tax advice. Guarantees are based on the claims paying ability of the issues. www.financialplannerla.com