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?
But wait — there’s more. “You mean to tell me that there are more benefits to this program that I have not been using?” Yes — asset protection. Not only can you protect these hard earned profits from taxes, but you may also be able to potentially shield them from creditors as well. This may provide you a chance to get off the rat race treadmill and retire someday. To potentially protect your assets, you don’t need to move your money to some far off location overseas, or bury the assets on a deserted island. There are two powerful protections given to pension plan assets. The first is called BAPCA for short, or Bankruptcy Abuse Prevention and Consumer Protection Act. Retirement funds in any account exempt from taxation under certain sections of the Internal Revenue Code, among others, are exempt property from a bankruptcy estate, under either the “opt-out” state exemptions or the federal exemptions.
Additional asset protection comes from the anti-alienation provisions of the Employee Retirement Income Security Act (ERISA) section 206(d) and IRC section 401(a)(13) that have protected tax-qualified retirement plans from the claims of creditors of plan participants and their beneficiaries, except in divorce, federal tax levies, or certain criminal actions. (“Is Your Retirement Plan Really Safe?”; Journal of Accountancy, April 2005, Richard A Naegele and Mark P Altieri.)
Is a cash balance plan the panacea to all things tax and creditor? No. Laws and court rulings are constantly evolving, but if you would like to reduce your tax liability and improve protection from creditors, these plans are certainly worth a look.
Rich Wagner, CPA, MAcc, is a tax reduction and investment expert. If you’d like more ideas on protecting , saving and growing your money call him at 801-657-4459, or email at firstname.lastname@example.org