Defined benefit plans, otherwise known as "pension" plans, are ideal saving and planning vehicles for taxpayers consistently earning in excess of $200,000 per year (net of expenses) through a closely-held small business.
Previously, in "Retirement planning through payroll" (Oct 13 2016), I broadly introduced the two major models of defined contribution retirement plans (IRA-based plans and 401(k)-based plans). In this update I will discuss the mega tax-saving and retirement-planning tool that is the defined benefit plan.
Let's cut to the chase - defined benefit plans can help taxpayers defer over $100,000 of taxable income per year.
That's a whole lotta moola.
In doing so, defined benefit plans create ginormous tax deductions. A common scenario (outlined below) involves annual tax savings of roughly $20,000.
A whole lotta moola.
What you need to know:
Defined benefit plans can be utilized in addition to most defined contribution plans, making them ideal for taxpayers who already max out their IRA-based or 401(k)-based retirement plans.
Defined benefit plans must be established by the last day of the tax year (December 31 for most of us).
Funding of the plan can be made as late as the due date of the tax return (so March 15 of the following year, but no later than September 15 with an extension).
The defined benefit limit--that is, the maximum annual benefit paid out by the plan--is set forth by the IRS as the lesser of:
100% of the participant's average salary over highest three consecutive years of earnings, or
$210,000 (for 2016; $215,000 for 2017).
The annual tax deduction is the amount needed to make the plan "whole," and is determined annually by a paid actuarial calculation pursuant to plan specifications.
For example, a taxpayer, age 50, wishing to retire at the age of 65 with an annual income of $120,000, needs to have $1,245,559 'in the bank' at retirement age (assuming 5% growth). To get to $1,245,559, annual contributions of $57,722 need to be made (for 15 years @ 5% growth). Therefore, the annual deduction will be very close to $57,722 per year. At a 35% tax rate, that deduction translates into roughly $20,000 in tax savings every year.
A few things to keep in mind:
Defined benefit plans are costly to maintain (largely due to their administrative complexity).
Excise taxes apply if too little or too much is contributed (i.e., funding is rigid).
Defined benefit plans are tax 'jewels' for dual-income households and lucrative small businesses with stable and predictable income. If you think a defined benefit plan may be in your future, contact your advisors today and tell them you want to make a mega tax move!