Changes in tax law enhance the appeal of these traditional pensions.

For successful small-business clients who groan about taxes and cry about their retirement savings, now is the time to consider defined-benefit plans. Provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 let business owners and professionals make significantly larger tax-deductible contributions to DB plans than they could a few years ago.

For example, a 50-year-old business owner who contributed $62,000 to fund the top benefit under prior law can now contribute $110,000 or more, Nashville enrolled actuary Bruce Temkin told advisors at the recent NAPFA 2003 National Conference. A 40-year-old can put in $60,000-plus, up from $30,000.

DBs assume that the plan assets will earn "x" and accumulate to fund pre-determined retirement income benefits of up to $160,000 annually at age 62 for participants. The plans are appropriate for entrepreneurs who are seeking to defer more each year than they can with a defined-contribution plan, says Jim Van Iwaarden, a consulting actuary at Van Iwaarden Associates in Minneapolis. For 2003, the maximum defined contribution deferral is $40,000, or for age 50 and up, $42,000.

A DB can be used for any type of business entity, even if there are no employees. Certain costs of new plans established by businesses with 100 or fewer employees may qualify for a tax credit during the plan's first three years, or for the first two years plus the year before the plan became effective.

The catch is that contributions to a defined-benefit plan are mandatory, although creative actuaries typically build in flexibility so that a smaller amount, or none at all, will be due in a lean year. Moreover, the plan is a promise by the business to provide a specified benefit; if the plan assets don't earn the actuarially assumed rate of return, the employer has to make up the difference with additional contributions. Accordingly, the best candidates for DB sponsorship are successful businesses with stable profit streams, not unproven start-ups or enterprises reveling in a windfall year, says Stephen Sutten, an employee-benefits specialist at Minneapolis-based accounting firm Larson, Allen, Weishair & Co.

Another reason that DBs are best for businesses with a history is that over the years, the Internal Revenue Service has taken the position that these plans must be established with the intent to provide a permanent program of pension benefits. In other words, a DB requires a long-term commitment to the funding obligation. "You've got to tell the client that," Sutten says. A plan can certainly be terminated after several years-and in practice, many are-but it is wise to do so for a valid business reason that was not contemplated when the plan was established, he says.

Be a Hero-Cut Taxes

Monster contributions are only part of the payoff. You also want to slash the client's tax bill, says accountant-advisor Gerald Townsend, who implemented a DB for an owner earning more than $250,000 per year. "He was concerned about his six-figure contribution commitment-we had a very long conversation about that-but he was even more concerned about the taxes he was paying," says Townsend, operator of Townsend Asset Management in Raleigh, N.C.

DBs are neat for sheltering second incomes from taxation. Temkin recently set up one for a married self-employed accountant whose $50,000 annual income wasn't needed to cover the household's living expenses. Given her earnings history, Temkin was able to devise a DB that allowed the accountant to contribute her entire business income. "You usually don't think of someone making $50,000 or $60,000 as a candidate for defined benefit, but they can be," he says.

Despite the potential savings, you need to be aware that a punishing 50% non-deductible excise tax applies when terminating a plan that is overfunded. This can occur when returns are more favorable than anticipated or if long-term interest rates rise, Temkin says. When starting a new plan, "make sure that you develop an exit strategy with the actuary you're working with (so) that if the plan is terminated, you won't be overfunded," he advises.

Hot Products

To help owners capitalize on the higher contributions available, pre-packaged, off-the-shelf products have begun to appear in the marketplace. Of these, 85% are for owner-only enterprises-"That solo doctor, lawyer, or real-estate professional," says Timothy Connor, director of marketing at Milwaukee's Metavante Wealth Management. Metavante's OnePersonPlus is a defined-benefit plan for businesses with up to five employees that allows the advisor to manage the plan assets.

The most contentious product in the DB world today is undoubtedly the 412i plan, named for the Internal Revenue Code section that offers special treatment for plans that are fully-funded by guaranteed insurance company products. The guarantees within the insurance vehicles eliminate the business owner's risk that the plan assets will earn less than the actuarially assumed rate, says Josh Jenkins of The Hartwood Group LLC, a 412i provider in San Diego. A 412i is also relieved of annual certification by an actuary, a requirement that other DBs must meet. That lowers the cost of running a 412i. But the client must pay for insurance, which can be expensive.

Although this variant has been around for decades, the super-sized contributions now available in light of the legislative changes have sparked new interest in it. One 412i Web site trumpets a contribution of nearly $500,000 for a 55-year-old owner with no employees. Yet the jumbo deductions and abuses such as insurance in excess of the amount permitted as an "incidental death benefit" have caught the eye of the IRS, and new regulations aimed at curbing abusive plans are widely expected soon. Policies with springing cash values are especially likely to be affected, insiders say. In the midst of uncertainty, some financial professionals are avoiding 412i's entirely.

There is also debate about the applicability of the confiscatory excise tax. Proponents of the plans say that a 412i will trigger the tax only when a client has a death benefit beyond incidental limits or if the plan is poorly designed. Detractors assert that the colossal contributions can quickly lead to overfunding. Best bet for the advisor: Before adopting a 412i for a client, make sure it won't be overfunded in the event that the plan is terminated. Ask whether the client will be able to access the plan assets without incurring the tax, and whether there are any other circumstances that could trip the levy. Again, you should develop a careful exit strategy at the time of plan inception to preclude potentially disastrous tax consequences later.

If you do go the 412i route, be sure to use a highly rated insurance carrier, Jenkins says. While many 412i providers target businesses with ten or fewer workers, some offer plans for companies with hundreds of employees.

Favored Plan Designs

Many older owners who have employees are now adopting tested cash-balance plans. These let the owner stash a lot for himself, and little for the workers. In one example presented at the NAPFA gathering, Temkin showed that a 53-year-old business owner was able to save $110,000 while making contributions of just $21,300 for a roster of four employees ranging in age from 25 to 55. With a traditional DB plan, on the other hand, the cost of staff contributions would probably be prohibitive.

Tested cash-balance plans are also attractive for organizations with multiple owners, such as medical groups or law firms. In contrast with a traditional DB, which does not maintain separate account balances for each participant (making it difficult to allocate the total plan pie among participants), a cash-balance plan does. "A cash-balance plan looks and feels a lot like a defined-contribution plan," says Van Iwaarden.

This is important at many law firms, for instance, because if a partner wants to contribute an additional amount to the retirement plan, her pay is reduced by the same amount. "The (paycheck) reduction is explicit, so the attorney will want to see that money coming back to her," Van Iwaarden says. "In a cash-balance plan, everybody has their own account, so there is a direct link between the money that goes into the plan for an individual and the amount that comes out to her." Cash-balance plans don't promise a lifetime income in retirement. Instead, a retiring participant's account balance, which grows at a rate stated in the plan, can usually be withdrawn in a lump sum or converted to a series of income payments.

A final approach to consider for clients is a DB-DC combo. Historically, IRC Section 415e prevented you from simultaneously maxing out benefits under both types of plans, but that rule was repealed not long before the 2001 tax act was enacted. Now clients can double dip. A common tactic involves adding a DB to an existing profit-sharing plan. In these cases, "the employer is really switching his thought process," says Sutten. "The DB is going to be the main retirement plan, and any discretionary contributions which are affordable beyond that in good years will fund the profit-sharing benefit."

Cash-balance and 412i DB plans can also be combined with a DC. For instance, The Hartwood Group is layering cross-tested 412i plans on top of existing profit-sharing plans with the goal of creating a combo in which 80% or more of the contributions are skewed to the owners. "At least 40% of all eligible employees, up to a maximum of 50 individuals, must participate in the 412i, while the remaining workers go into the profit-sharing plan," Jenkins explains.

Good candidates for this structure are large doctor groups with more than ten employees, he says. "The physician-owners end up in the 412i and are able to make contributions of $100,000 to $300,000-plus annually, while the employees in the profit-sharing plan receive a safe-harbor contribution that is a percentage of their salary."