Contrary to popular belief, classic pension plans have not disappeared.
Corporations mostly have jettisoned them, but highly profitable small businesses are giving them a second look, deciding to adopt old school, employer-funded retirement plans.
The tax breaks may be substantial. In fact, if these plans are funded with insurance contracts, 100 percent of the plan contributions may be tax deductible for a business. While a SEP (a defined contribution plan) permits a business owner to save thousands of dollars for retirement annually, that might still leave a huge chunk of the net income to be taxed at 33 percent or 35 percent (or 36 percent or 39.6 percent, if the Bush-era tax cuts expire in 2013).1,2
There is no cap on how much you can save. IRAs, 401(k)s
and SEPs all have annual contribution limits. Traditional employer-funded pension plans do not. Business owners have the potential to accumulate millions for the future through such a vehicle.
For the record, the IRS does limit the yearly retirement income a participant in a defined benefit plan may receive. In 2012, the pension benefit resulting from such a plan may not exceed a) $200,000 or b) 100 percent of the participant’s average compensation across three highest-paid consecutive years of service.3
If you are earning well into six figures and you are 45 or older, you may have entered the sweet spot when it comes to defined benefit plans. You will presumably be in your peak earning years, and yet, you may need to accelerate retirement savings. A defined benefit plan offers the possibility to do just that.
What are the downsides? Cost and complexity. Actuaries have to be involved (and paid) when you have one of these plans. You need an actuary to perform regular and annual calculations and valuations to see that the plan is being properly funded. In addition, the pension benefits need to be insured through the federal government’s Pension Benefit Guaranty Corporation (PBGC). In exchange for that service, the business must pay the PBGC annual premiums.4
An actuary must determine the annual employer contribution amount needed to fund the plan (typically adjusted yearly in light of investment performance) and the actuarial formula used to make contributions per worker. The business must fund the plan year in and year out, regardless of how well it is doing.
Could a family business adopt a traditional pension plan? A long-established family business with a payroll made up of a few family members may find one of these plans highly attractive. The plan contributions can be large, and the benefits can go directly to family members and/or their spouses.
What businesses are good candidates? Accounting, consulting and medical practices are often good fits for these plans. Seeing how many baby boomers have elected to continue working as consultants, you may see interest rising in them during the coming decade.5
Gold Leaf Advisory is located at 2929 N. Power Road, Suite 101. For more information, call (480) 285-1998.
Citations:
1 – www.newyorklife.com/nyl/v/index.jsp?contentId=14001&vgnextoid=8fffdcec569d2210a2b3019d221024301cacRCRD [8/2/09]
2 – www.taxpolicycenter.org/taxtopics/2013-Allow-top-two-rates-to-rise.cfm [7/10/12]
3 – www.irs.gov/publications/p560/ch04.html#en_US_publink10008920 [10/20/11]
4 – http://psabenefits.com/downloads/Small%20Businesses%20&%20Defined%20Benefits%20Plans-Oct5.pdf [10/05]
5 – www.fa-mag.com/fa-news/9457-high-income-clients-save-more-with-these-underutilized-retirement-plans.html [12/21/11]