Tax reform and its 20-percent pass-through deduction for qualified business income (QBI) has created a new use for an old retirement tool: the pension.
Pension arrangements (aka defined-benefit plans for small businesses) can be used by doctors, law partners and wealth managers who want to whittle taxable income to qualify for the QBI deduction.
“Individuals whose earnings are too high to take advantage of the QBI deduction may be candidates for a DB plan in combination with defined contribution plan, such as a 401(k),” said Taylor Hammons, head of retirement plans at Kestra Financial, Austin, Texas. “Their goal is to reduce their taxable income below the threshold for phase-out of the QBI deduction.”
If a joint filer’s taxable income is below $315,000 (below $157,500 for any other individual filing status), the taxpayer can claim the deduction on their income from an eligible profession. If the taxable income before QBI exceeds $415,000 ($207,500 for other filing statuses), no QBI deduction can be claimed. Income amounts in-between are subject to phase-outs and smaller deductions. Some owners of pass-throughs also can’t claim the deduction because certain fields such as health, law, accounting or consulting generated the income.
“We’ve been working with our higher-income clients for many years who have had the desire to defer substantial income in excess of what a typical 401(k) plan would allow. The cash-balance defined benefit plan has been very useful,” said Brian DiFilippo, CPA and partner at D’Arcangelo & Co., Poughkeepsie, N.Y.
A doctor or attorney who is a joint filer and a partner in a medical or law partnership and who has taxable income of $500,000 can’t claim the QBI deduction, said Neil Becourtney, CPA and partner in the Eatontown, N.J., office of Cohn Reznick. “If this taxpayer can generate a $200,000 retirement contribution through establishing and contributing to a tax-qualified defined benefit plan, taxable income would drop to $300,000 and the taxpayer could claim a QBI deduction.”
Cash-balance DB plans have significantly higher contribution limits than most other types of retirement savings plans; these limits also increase for older workers. “We’ve had this conversation with most clients already. Now it’s more about how much to fund,” said Jay Freeberg, CPA/CFP and partner with Janover LLC in New York. “Most clients don’t like the ‘annual required funding’ of a DB plan, especially when they have more than a few employees.”
Significant issues also accompany tax-qualified cash balance DB plans. They must comply with federal tax and ERISA rules preventing discrimination in favor of highly compensated employees, and the owners need to meet the cash-flow requirements of funding retirement plan contributions for most if not all employees (typically 5 to 8 percent of those employees’ pay) – not to mention setup, administration and investment management costs.
“I use these plans for clients who are high earners who can contribute more than the SEP-IRA limit, Older clients can make larger contributions based on fewer years to fund their benefit,” said Robert Seltzer, CPA at Seltzer Business Management in Los Angeles.
“Cost of these plans is not an issue,” countered Leonard Wright, a CPA and wealth management advisor in San Diego, claiming that tax savings offset administration costs. “It’s like baking a retirement plan cake: The first layer is your 401(k), the second is your profit sharing and the icing is the cash balance.”