Wish you had a pension to help see you through your retirement?
Today, small business owners may be able to create their own with a Defined Benefit Plan.
Even if you are just a few years away from retirement these plans may deserve a look.
Hey there, big 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 superfund your nest egg. Or you may need to help neutralize the negative effects tax drag is wreaking on your ever-increasing income as an ultra-successful 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 big boost.
Pensions, schmensions
A few of you reading this may be lucky enough to still have a pension through your employer. But the days of working 40 years for a company with fabulous benefit packages - you put in your time then, upon retirement, are guaranteed an income for the rest of your life - 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 you 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 around 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 type of advance financial planning tool is called a "Defined Benefit Plan". One type of plan is specifically called a "Cash Balance Plan." Participants 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 claims paying ability of the companies you are working with on your plan.
Defined Benefit Plan contributions are mostly based a combination of your age and income. The younger you are the less you can contribute, 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, as well as tax deferral for the savings, your Fiduciary Financial Planner will be able structure these two plans together for you.
As with anything there are pros and cons. Let's take a look.
Ideal candidate for a Defined Benefit Plan
Cash Balance or Defined Benefits Plans are best suited for small-business owners (including the self-employed) who are facing high tax bills, and want to put away more money in a tax-deferred manner. For most of the many Defined Benefit plans I've set up over the years, lowering their tax bills now has been the main benefit 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 Defined Benefit 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 fully fund the plan over the next few years. The big tax now? Say hello to literally over a $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 the last few years leading up to retirement. They NEED to put away large amount of money if they wanted any chance of maintaining their standard of living into retirement. The huge tax benefits and deferral made it much easier to put even more money away. Making it easier to put more away, 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 thing. As with so many things in life (sigh), bigger benefits may come some bigger headaches.
Don't be dazzled by the dream of guaranteed lifetime income or 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 top. 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, IRA's or 401(K) distributions for Defined Benefit Plans will be taxed as regular income. To reiterate again these plan work best for people who can commit to at least 5 years of contributions. There are IRS penalties for taking money out prior to 59 ½, and further early distribution may put the viability of the plan in jeopardy.
Playing catch up
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 and 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 or to another 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 Certified Financial Planner™ working with your CPA should be able to help you figure out if this vehicle is the right option for you. More importantly 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.
DAVID RAE, CFP®, AIF® is a Los Angeles-based retirement planner with Trilogy Financial Services. He has been helping people reach their financial goals for over a decade. He is a regular contributor to the Advocate Magazine, Investopedia and Huffington Post as well as the author of the Financial Planner Los Angeles Blog. Follow him on Facebook, or via his website www.davidraefp.com
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