Rich Wagner: Using cash balance plans to improve your retirement
As Yogi Berra said, “It’s tough to make predictions, especially about the future.” I know I’m going out on a limb here, but I have a strong suspicion that tax rates are going — up!
I know, no great surprise, as our elected officials have managed to get this country into record amounts of debt. Unfortunately, at some point debts have to be paid and my hunch is that process will begin picking up momentum sooner than later. The tax man cometh.
I know one business owner who told me that his goal was to reduce the size of his company so that he did not make more than $250,000 per year in income because he was told that if he made more than $250,000, his taxes would go way up. I don’t think reducing the size and success of our companies bodes well for employees, our economy, and yes, even the tax base. May I suggest what I feel to be a better option? Keep growing your company, make more profits, keep hiring people, but implement strategies to reduce your tax burden as well.
Behold, the defined benefit plan. Let’s start with the basic concept. Unlike defined contribution plans which limit how much you can put into them each year (401k, SEP, SIMPLE), defined benefit plans limit how much you can pull out of them each year. This difference in structure means that you can potentially put hundreds of thousands of dollars per year into the plans because you need to build up an enormous pile of money in order to pay a benefit to the plan participants for life. Many government employees have this type of plan, but small business owners also have the option to create these great benefits as well.
Defined benefit plans promise to provide a participant a monthly benefit beginning at retirement and payable as long as he or she lives. The amount of this benefit is usually based on years of service and how much the participant earned during his highest-paid three consecutive years of employment. The maximum annual lifetime benefit payable to a participant with a retirement age of age 62 or older was $200,000 in 2012.
An individual with a maximum benefit limit of $200,000 per year would need to have more than $2.5 million in the plan at age 62 to fund this benefit of $200,000 per year for the rest of their life. A participant who is 52 years old only has 10 years to make tax-deductible contributions of approximately $200,000 per year to total the needed $2,500,000+ with interest, which creates much larger potential contributions to the plan. Now you may be thinking, I like the potential to make a tax-deductible contribution of over $200,000 per year, but what if I have a down year and cannot make that large of a contribution? The good news is that you have a range of funding options each year. Some plans I have worked on have a range from tens of thousands to hundreds of thousands per year. This means that you could potentially fund very little in a down year and hundreds of thousands in a great year.
So what is the big deal about these plans? Let me explain by way of an example. Let’s suppose you decide to implement a defined benefit plan and are able to put $200,000 per year into one of these plans. If you are in the top tax bracket of 35 percent federal and 5 percent state tax, that means tax savings of $80,000 per year. If you are in that top bracket now, brace yourself for likely higher taxes in the very near future. However, the tax knife cuts both ways, which means you can expect a larger tax benefit from those deductions in the future as well. “So if I can save $80,000 per year in taxes and I put that away every year for 10 years, that would provide me with a nest egg of $800,000 plus growth?” Yes, that’s what we’re talking about. Now I ask you, where else can you put your money to generate that kind of savings? Pretty tough to beat right?
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