David Rae Contributor
CFP who writes about having a Wealthier Healthier and Happier Life.
Paying fewer taxes is imperative for small business owners and the employed. The year 2020 will be challenging for many business owners, but if your business is still bringing in a nice income, you could benefit greatly from setting up the right retirement plan. For the top-performing business, this may be a combination of a 401(k) plan with a Defined Benefit Pension Plan, which could save you potentially hundreds of thousands of dollars in taxes.
Business owners who feel like they are behind when it comes to retirement planning can reduce their tax liability, and play catch up on their retirement savings, by adding a Defined Benefit Pension Plan on top of a Profit Sharing 401(k) plan. With potential tax savings north of $100,000 per year, it amazes me that more financial advisors are not discussing this valuable retirement planning technique with their clients. I am going to go out on a limb and guess neither your CPA nor Financial Planner has never mentioned setting up a Defined Benefit plan to you.
Somewhat proving my previous point, a prospective client left me a voicemail saying, “I just read your post about pension plans for small business owners; why didn’t my CPA tell me about this?” She also missed the essential opportunities to save more for retirement with a 401(k) Profit Sharing plan. Instead, her tax pro told her she made too much money to contribute to a ROTH IRA. Even if she was eligible with her high income, putting away just $6,000, per year, into a ROTH IRA was not going to give her a secure retirement.
Additionally, this individual had saved more than $200,000 last year. Most of that money was just sitting in her checking account, which meant she was unable to receive a tax deduction and only able to earn minuscule interest from the bank. These issues will be corrected for 2020 and beyond.
Retirement Planning for Business Owners
Running a business is stressful, and cash flow can be an issue much of the time. You keep reinvesting in the business to help it continue to grow. The goal is to eventually cash out, sell the business, and have enough money to finally enjoy life. Or perhaps, you love what you do and can’t imagine ever retiring. Not to be a Debbie Downer, but it is rare for owners to be able to sell their business for enough money that will allow them to fund what could easily be a 30+ year retirement.
For those who decide they want to retire someday, getting serious about saving and, in a lot of cases, playing catch-up is often the case. Minimizing taxes can make that process run more smoothly. If nothing else, funding a retirement account will help you lower your current tax bills or, perhaps, reduce your risk of a pandemic (think the next Coronavirus) putting you out of business.
Retirement Plans for Small Businesses When you own your own business, you have a variety of retirement plans to choose between. As a financial planner who works with many business owners, I help people choose the best retirement plan for their specific retirement needs and business structure. In some cases, we may use Roth IRAs or Traditional IRAs, while others use SEP IRAs. For those who need to save even more (or are looking to minimize more substantial tax bills), Solo 401(k) plans are quickly growing in popularity.
They have recently become easier to set up and cheaper to maintain. 401(k) Profit Sharing Plans may be the best bet when looking to save around $57,000, or less, per year. Business owners who are trying to save the absolute maximum amount, or get the most substantial tax savings, may be best served with a 401(k) Profit Sharing Plan combined with a Defined Benefit Pension Plan.
What is a 401(k) Defined Benefit Pension Plan Combo?
Pension law will allow a company to essentially combine a cash balance pension plan with a Profit Sharing 401(k) plan. When these business retirement plans are structured properly, business owners may have the ability to put tens of thousands of additional dollars into retirement accounts each year. Did I mention you get a tax deduction for every dollar you contribute?
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What are the downsides of a Defined Benefit Pension Plan?
For business owners with employees, you will be required to make profit-sharing contributions, and offer a matching contribution for them, if you genuinely want to make the maximum contributions for yourself. For 2020, a 401(k) would allow you to put away up to $57,000, plus an additional $6,500 if you were over 50. Additionally, you may be able to put up to $100,000, or more, into a Defined Benefit Plan. The exact contribution limits will vary on the Pension Plan depending on your age, income, employee payroll, and how much you already have invested in the plan.
Defined Benefit Pensions and 401(k) plans often have setup costs and may require ongoing record-keeping fees. With a Defined Benefit Pension plan, you will also likely be required to have an actuary review the plan each year to keep it compliant. While not cheap, the cost of these types of plans pales in comparison to the value of the potential tax savings.
The biggest drawback for pension plans is that you will likely need to commit to minimum funding levels for about five years. The minimum contribution levels are tied to your business profits. If business declines, your commitment will also be lowered.
Keep in mind, the contributions for your employees are also tax-deductible. With proper planning, much of the funding can go towards the owner. The plan I funded this week had 90% of the company’s money going to the owners of the business. These percentages will vary depending on the size of the business, payroll, the number of employees, etc.
Who Benefits Most from a Defined Benefit Pension / 401(k) Combo Stack Plan?
Self-employed or small business owners with high incomes are drawn to these types of plans. Higher incomes result in more tax liabilities that these individuals want to minimize. Similarly, the more you make, the more you will need to save for a comfortable retirement. With a combo, you could potentially stash away $200,000 per year, pre-tax, perhaps even more. These plans work out well for family-owned businesses or spouses who work together.
If you are looking to save less than $57,000 per year, a typical 401(k) plan may be the better option. Keep the 401(k) / Defined Benefit Pension combo on your radar if you are looking to save more now or in the future. Your CPA or financial advisor likely will not recommend it.
Assuming the top 37% tax bracket, maxing out this plan could save you more than $55,500 in federal taxes. Also, your state tax bill will be reduced if you live in a state with income taxes. For those trying to stay below the new 20% tax break for pass-through income limits, this can help in that respect as well. It’s not what you make but what you keep. With that in mind, don’t make strategic tax planning something you do just once a year. The cost of bad tax planning is too dang expensive.
Using Pension 401(k) Stack to Get More of the Pass-Through 20% Tax Break
You may have heard about the new 20% tax break for pass-through entities, which started in 2018. Some of the more common examples include sole proprietors, S Corps, LLCs, and partnerships. If you are running a pass-through entity that would be considered a “service,” the 20% deduction will phase out as your income increases. For single filers, this phaseout begins at $163,300 in 2020. The numbers are a little higher for married couples with the phaseout starting at $326,600.
Look at it this way; your retirement plan contributions will give you a deduction for contributing. Those contributions may also help lower your income threshold, listed above. If so, you will be able to maintain the 20% pass-through tax break. You can either earn less money or, in some cases, write a check to yourself in the form of 401(k) and pension contributions. Which would you prefer?
If a Defined Benefit Plan is appealing to you, ask your current financial advisor and CPA if they are able to help you set up this valuable tax-saving plan. If they aren’t able to help or don’t know how to do it, consider finding a Certified Financial Planner who is an expert with Defined Benefit Pension Plans and up to the task of helping you invest for the retirement you deserve.
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