How to Defer More Tax and Save More for Retirement
A defined benefit plan could be a good way for you to shelter more of your income and put more aside for retirement. These plans are especially useful for business owners whose companies are generating high profits.
Unlike a 401(k), where combined employee and employer annual contributions are capped at $53,000 in 2015, a defined benefit plan might allow you to set aside as much as four, five or even six times that amount. Like a 401(k) plan, it also defers taxes until the funds are distributed in retirement. An added tax advantage for the business is that the company makes the deductible contribution, not the employee.
But for all its positive features, determining whether a defined benefit plan is the right choice for you and your financial situation is not a simple matter. Smith & Howard Wealth Management can help you figure out if the pros of the plan outweigh the cons, how much you could or should contribute, and how this plan might be part of your retirement planning.
How much to put into the plan is determined by a formula considering several factors, including current age, retirement age and how much of a retirement benefit is desired. Below are key questions to start the process of designing your defined benefit plan.
What’s Your Age Today?
Your age today is the starting point in determining how much time is available to build the benefit. Business owners who are in their late 40s to early 60s and who have focused on building their business rather than their retirement savings are great candidates for this plan. Because it allows more to be contributed than a 401(k), it helps business owners who are older than their employees build their nest egg faster. Younger business owners may not benefit from a defined benefit plan since there is more time for them to save for a predetermined benefit amount, and this dilutes the tax benefits.
These plans have higher costs compared to a 401(k), but the costs may be more than offset by the advantages of being able to save say $300,000 annually for retirement. And odds are that if you’re able to set aside this amount, you’re in a higher tax bracket. Deferring taxes on this amount of income may put you into a lower bracket.
At What Age Do You Want to Retire, and How Much Retirement Income Do You Want?
The age you want to retire and the amount of retirement benefit desired (within IRS guidelines) is the ending point for determining how long and how much you have to save. Your retirement age compared to your employees’ is another consideration. The plan must include all eligible employees – the younger they are, the less you’ll need to contribute for them since they’re farther from retirement age. This makes the defined benefit plan a great option for business owners who may be facing a shorter runway to retirement than their employees.
Are the Profits of Your Business Steady?
Good candidates for a defined benefit plan are usually owners of a well-established company that has had strong cash flow and has a positive outlook for future profits as well. Because you will need to commit to making the same contribution every year (or face possible penalties), businesses whose profits seesaw annually are not as well suited to a defined benefit plan.
The fact that these plans are defined by the benefit – the nest egg you need to fund your retirement income stream – makes those steady profits important for another reason. Actuaries help calculate the right amount to put into the plan based on several assumptions, including an interest rate for the growth of the assets. If your fund performs below actuarial assumptions, you will need to put more in the plan. On the flip side, if your performance is above that estimate, you will contribute less to the plan, and the business will owe more tax.
And the size of the company, specifically the ratio of owners/partners to employees, has a bearing as well. As a general rule of thumb, a defined benefit plan is best for companies that have at least one owner for every five employees. A higher ratio of employees makes the plan less cost-effective.
Case in Point
While doing some planning for a client, “John,” the owner of a professional services firm, we found his living expenses were much lower than his level of income. The only employee in his company, he had a high income and the ability to spend far less than he earned. These two criteria flagged him as the kind of client who a defined benefit plan could help. Rather than have the excess income taxed (as either corporate or personal income), such a plan could help John to defer the tax and grow his savings tax deferred.
In discussing the opportunity, we found it was more important for him to shelter as much as possible rather than target a specific amount for a retirement benefit. Since his business’s profits were steady, he could feel comfortable with the amount he wanted sheltered each year. Smith & Howard Wealth Management introduced John to an actuary who determined that $250,000 could be put into the defined benefit plan to satisfy both his needs and the plan’s requirements. We then designed an investment strategy to help him reach the targeted rate of return required by the plan.
Want to Learn More?
If you want to find out if a defined benefit plan would help you, or if you have other questions, contact your wealth advisor, or call Smith & Howard Wealth Management at 404-874-6244. One of our experts will be glad to discuss and determine if a defined benefit plan is right for you.