Ask successful small-business owners if they are happy with their annual IRS tax bills and most will moan and groan. That was the case with Bob Johnson, founder and CEO of Johnson Insurance & Financial in McKinney, Texas. Fortunately, he found a way to shave $200,000 off his tax bill in just three years. Johnson's tax savings came from an inconspicuous source: a defined-benefit plan.
While these traditional pension plans have become almost extinct among large corporations, they can provide valuable benefits for some small-business owners in the form of large tax breaks and hearty retirement savings — especially for high-earning small-business owners who are over age 45, behind on the retirement savings game, and anxious to contribute large sums to make up for the lag. That's because business owners can contribute a lot more to these defined-benefit plans than to defined-contribution plans.
In fact, most people are able to lock away three to four times more with defined-benefit plans. Annual retirement income is currently capped at $185,000. The most a person can accumulate — based on actual calculations — is around $2 million.
Johnson's financial services business generates a healthy net income of about $500,000 annually. Until three years ago, he was conscientiously contributing the maximum allowable for his SEP, which was around $40,000, a year. But being in the 35 percent tax bracket, he still had to fork over more than $100,000 to Uncle Sam. So Johnson took the advice of another financial advisor: He opened a defined-benefit plan and began socking away $200,000 annually. In addition to shaving several hundred thousand dollars off his tax bill, he has accumulated more than $700,000 in his plan, including gains.
Now, he's touting the virtues of defined-benefit plans to many of his clients. “This is an efficient way to create million dollar estates since you're able to deduct maximum amounts of money on your taxes, keep it, invest it conservatively and let it grow.” In essence, the defined-benefit plan lets Uncle Sam subsidize small businesses to rev up their retirement funds.
“The financial services market is starting to realize these plans make sense for small-business owners,” says Sarah Simoneaux, president of Simoneaux Consulting Services, and past president of the American Society of Pension Professionals and Actuaries.
A Good Fit
Of course, defined-benefit plans aren't for everyone. They are best for older business owners who want to catch up on retirement savings in a short period of time and whose businesses have stable cash flow, says Simoneaux. Ideal candidates are high-income, self-employed individuals, and owners of one- to five-person businesses aged 45 and older, such as doctors, dentists, realtors, consultants and even financial advisors, says Karen Shapiro, CEO, Dedicated Defined Benefit Services. The same contribution formula applies for both the business owners and their employees. Bosses with a large staff, highly paid employees or older workers nearing retirement age will most likely find these plans cost-prohibitive. Those who have a small staff, part-timers or younger employees will reap a much larger percentage of the retirement benefits.
The Basics: THE DIFFERENCES BETWEEN A DEFINED-BENEFIT PLAN AND A DEFINED-CONTRIBUTION PLAN.
|DEFINED-BENEFIT PLANS||DEFINED-CONTRIBUTION PLANS|
|CONTRIBUTION FUNDING||Solely by Employer.||Employer and employee.|
|CONTRIBUTION LIMITS (2008)||$185,000||$46,000|
|BENEFITS||Predetermined using formula based on earnings and market performance history, years of employment, retirement age and other factors. Guaranteed.||Based on contributions. No guarantees.|
|SUITABLE FOR||High-income business owners who want to make large catch-up contributions.||Companies with fluctuating profits and employers who prefer discretionary contributions.|
|LIABILITY/COST||Employer retains liability for paying pension benefits; plans can be complex and costly to administer.||Employer liability ends when contributions are made; plans are relatively simple and inexpensive to administer.|