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.