| 04 November 2010
Hate Paying Taxes? Look into a small defined benefit plan
Many individuals aren’t aware that there are great retirement plans for small business owners and professionals, that allow you to contribute 2 to 3 times more than your current SEP, profit sharing plan or 401k. The plans I’m talking about are small Defined Benefit Plans.
While big business are getting away from defined benefit pension plans small business owners, doctors and sole practitioners are flocking to these small pension plans in order to reduce current taxes by putting $100,000 or more each year into their own pension plan.
These plans make the most sense for someone over 45 years old, has 0 employees (other than a spouse), consistently earns more than $150,000 a year (could be salary & profit) and wants to contribute more than other plans allow. Ideal candidates are physicians, real estate agents and high earners considered an independent contractor, sole proprietor or someone with a small corporation.
Other plans are simple to set up and administer and this is what we use for most of our clients. The small-defined benefit plan is more costly and complicated to set up and maintain but for the right situation it can be a home run for tax savings.
Here’s how it works. With a small defined benefit pension, a plan participant makes annual contributions to meet a desired retirement savings goal. The contribution amounts are based on a complex formula that includes, among other things, your age, how much monthly income you'll need from the plan in retirement and how well your investments perform prior to retirement.
For example, if a 55-year-old man wanted to retire at age 65 with a fully funded pension of roughly $1.5 million, he would need to contribute a minimum of $120,000 a year over the next 10 years, assuming a rate of return on investments of 5.5%. That’s $120,000 a year before taxes. If you live in N.Y. that could be an immediate income tax savings of 40% or more each year. Once the annual contribution level is set, participants generally must continue to make those payments each year until the pension is funded in full or you terminate the plan.
In many cases (it all depends on your age) you can contribute an amount equal to or greater than your current earnings. This can be ideal for someone who has paid off his mortgage, put the kids thru college and now wants to save a tremendous amount of money tax deferred for retirement. At retirement, age 62 or when you terminate the plan you can roll the money into an IRA.
It is important for you to be sure the plan is right for you prior to setting one up. You should have your investment advisor and accountant involved in making the determination if this plan is right for you. You will also need to have an actuary involved to setup and maintain the plan. Your investment advisor will be able to help you get everything set up. The money can be placed and invested in a brokerage account so your selection of investments can be the same as what you would do in your current retirement plans.
I would suggest staying away from defined benefit plans set up by insurance companies that have high internal expenses and limit your investment selections. You should have the ability to move the plan account to any brokerage firm you want because this gives you flexibility to change brokers or advisors in the future.
The small defined benefit plan is certainly not for everyone but we like to use them if the client has the right financial profile and wants to save for retirement while significantly reducing their current taxes. You have until the end of the year to set the plan up and fund it. If you hate paying taxes and want to save for retirement I suggest you look into a small defined benefit plan.