For Highly Profitable Business Owners
One key to your financial independence is saving for your retirement in a tax-deferred and therefore tax-advantaged plan, whether you are self-employed, running a small business, or just freelancing for extra cash.
In our last post which is the part 1 of this series, we look at the best tax-deferred retirement plans for Self-employed, Freelancers & Small Business Owners. Then we were asked about highly profitable small business owners who want to, and are able to, contribute more than the $57,000 upper limit for SEPs or 401(k). What are their options?
The answer is, drumroll please, defined benefit plan.
Just like they say, the more things change, the more they stay the same. This is your father’s or grandfather’s retirement plan - the traditional “pension plan” that so many employers have stopped offering because they can’t afford it anymore. However, it can still be a great choice for older, highly compensated business owners with few employees.
Pro:
1. Defined benefit plans let you guarantee up to $230,000 in annual benefits in 2020 index. Let that sink in for a moment, this is annual income in your golden years. If you are dreaming of retiring to a quieter and small country in the tropics, this amount would allow you to live like a king.
2. You can contribute - and deduct - as much as you need to finance that benefit. You’ll calculate those contributions according to your age, your desired retirement age, your current income, and various actuarial factors. [An actuarial expert will be needed, please see our post about selecting one.]
3. A 412(i) plan, sometimes called a 412(e) plan, is a defined-benefit pension plan that is designed for small business owners. As this is a tax-qualified benefit plan, so any amount that the owner contributes to the plan becomes available immediately as a tax deduction to the company. Guaranteed annuities or a combination of annuities and life insurance are the only things that can fund the plan. This plan lets you contribute even more.
Con:
The biggest problem with the defined benefit plan is the required annual contributions. If somehow your business doesn’t have the money in one year or two, you still have to pay. However, you can combine a defined benefit plan with a 401(k) or SEP to give yourself a little more flexibility.
For example, you could contribute up to $100,000 to a defined benefit plan, but you’re not confident you can commit to that much every year. You might set up a defined benefit plan with a $50,000 contribution, then pair it with 401(k) for another $50,000. If business is poor in a particular year, you can choose to skip the 401(k) that year.
So, now after two posts, we’ve covered the menu of traditional employer-sponsored and tax-deferred retirement plans, let’s throw another wrench into the mix. Do you even want or need a traditional plan? Or would you be better off with an alternative? Perhaps even giving up the current tax break?
All of the plans we’ve discussed in part 1 and here so far assume that you’re better off taking a tax deduction for plan contributions now, then letting plan assets accumulate tax-free over time. Then when you need them for retirement, you pay tax on withdrawals, at ordinary income rates.
That’s a great strategy if your tax rate is higher now than it will be in retirement. You benefit now by avoiding tax on contributions, which puts more to work for you today. And you benefit later by paying less tax on withdrawals.
But that traditional pattern doesn’t always hold true.
Maybe you’re young, just starting your career, and your income is low.
Maybe you’re transitioning from one career or business to another, and your income is temporarily low.
Maybe you think that tax rates in general will rise. (Today’s top marginal rate for federal taxes may seem high at 37%, but that’s actually quite low by historical standards.)
Also, click here for our thoughts on “preparing for higher taxes” as we predict higher income tax rates in the future.
Sometimes, contributing to a traditional retirement plan creates a ticking tax time bomb and actually costs you money over the long run.
What then? Please stay tuned for Part 3, the last part of this series. We will discuss (future) tax-free retirement plans, which may be more beneficial in your individual case.
If all these are confusing to you, and you like to talk to a financial advisor, check out our thoughts on selecting a trusted advisor.
Are you looking to pay less taxes, legally, legitimately, and morally? Sign up here for our series of well-researched and defensible strategies grounded in IRS code.