How To Get The Huge Tax Savings From The Rich Person's Pension
By: David Rae - November 08, 2018
The Rich Person Pension is really for high-earning professionals wanting to supercharge their tax and retirement planning. While these pension plans skew towards the wealthiest among us, they do also provide benefits for the more rank-and-file workers who are lucky enough to have one of these plans at work. Just to be clear, this is not the type of pension plan your grandparents had. Workers from their generation worked for one employer for 40 years, invested little to nothing themselves but received a lifetime of income once they retired. That is a thing of the past.
While the reported death of the traditional pension plan for the average American worker is still true, there is one area of the pension market that is currently red hot: pensions for rich professionals and business owners. With some proactive tax planning, wealthy business owners can stash away hundreds of thousands of dollars, pre-tax, into pension plans. This can help lower tax bills from tens of thousands of dollars on the low end to hundreds of thousands of dollars on the high end. Hence the name Rich Person Pension.
The Basic of Pensions for Wealthy Professionals: What I like to Call the Rich Person Pension
We are talking about setting up a personal pension plan for people like doctors, lawyers, small business owners and anyone else with substantial self-employment income. More commonly referred to as a Defined Benefit Pension Plan or Cash Balance Pension Plan, this type of retirement plan typically will be combined with a 401(k) profit-sharing plan to maximize the allowable contributions. The reality is you have to be making a pretty good income to need or want to save beyond the allowed maximum of $55,000, per year, into a 401(k) (this is the total as the employee and employer). For those looking to save more stashing hundreds of thousands of dollars per year into a pension can really lower current tax bills.
While these pension plans have been around for years, they have grown in popularity under the Trump Tax Plan that went into effect for tax year 2018. Large contribution limits to pension plans help wealthy business owners get around the annoying income limits Congress created on pass-through businesses. Firms/Businesses/Professionals, making more than $315,000 (married) or $157,500 (single), will see their 20% Qualified Business Income Deduction (QBI), aka pass-through deduction, limited or even eliminated.
Contributions to a pension plan lower the overall profits of a business. That results in a lower taxable income for the business, which allows the business owner to keep more money. Hence, the surge – at least in my office- of people looking to set up pension plans. Still, many people are unaware that this type of plan is available to them. Similarly, not that many people are able, or willing, to sock away several hundred thousand dollars, per year, for retirement. Tax savings be damned. For those who are able and willing, the tax savings are huge. Would you rather write a check to Donald Trump or to your own retirement account?
Who Qualifies for the QBI deduction?
There has been quite a bit of confusion as to who will be subject to the QBI income restrictions. The Treasury Department has proposed regulations around who will qualify for this 20 percent additional tax deduction for pass-through income. Essentially, this tax break slashes the top tax rate from 37 percent to just under 30 percent for the pass-through income of top earners. For 2018, that means income above $500,000 for singles, $600,000 for married couples. That is a significant difference and, as you can see, one that penalizes married folks. Earners within that income range are the top 1% of earners nationwide. But in states like California, you won’t even be close to cracking the top 1%.
Top-earning service professionals are mostly subject to the income limits of $315,000 (married) or $157,500 (single). Hopefully, many of those high earners are planning ahead to get below those income limits in order to take full advantage of the tax law’s biggest gift to individuals. Even with the 20% QBI deduction, pass-through businesses will still pay substantially more taxes than the new lower corporate tax rates. But don’t run out and change your business to a C-Corp. There are many disadvantages there as well, which will be covered at another time. Potentially, one of the best options to get below the aforementioned income limits is to make large contributions to retirement plans, like 401(k) profit-sharing and cash balance pension plans.
Only a “Specified Service Business” will be subject to the income restrictions. As a financial planner, I’m personally upset that I’m stuck with an income restriction while the commissioned insurance salesman down the street is not. That is just one example of the fine print in the new Tax Cut and Jobs Act (TCJA). Additionally, there will be even more upset people, who learn of those changes when filing their 2018 taxes, next year. While many people are expected to see their taxes go down this year, I’m expecting mine to jump about 20%. All other things being equal. I just spoke with a CPA this morning (who wished not to be named) who stated, “It is estimated that more than 70% of Californians’ tax bills will go up this year under the alleged “Trump Tax Cut.”” Most people, who will see their taxes go up, live in high-tax states and have well above average incomes.
I’ve written quite a bit about these types of retirement plans in the past. Normally, I would propose them to clients who could really benefit from them. Now, people are starting to call and ask about them and CPA’s are contacting me to help find more ways to lower their business clients’ sky-high tax bills.
Deadlines and Contributions
Defined-benefit plans are often set up during the last few months of the year. That allows for an in-depth analysis of how much a business owner can contribute and what that will mean for the owner’s overall tax liability. Plans must be set up before year end, so be aware of the coming holidays. It can take several weeks to complete a plan design so do not procrastinate until the last minute.
The good news is those plans don’t need to be funded until you file your taxes the following year. So, if you are just reading this now, in late 2018, and realize you could benefit from putting a few hundred thousand dollars into a pension plan but don’t have the money handy, you have some time to come up with the full amount.
Keep in mind, you will generally need to make contributions for your employees. If you have them. Each participant will know, each year, how much they hold in the plan individually. As the employer, you will make retirement contributions according to a pre-set formula and manage all participants’ investment portfolios collectively, usually with the help of a financial advisor. You should be spending your time running your business not dealing with financial planning or tax planning.
Pension plans should be designed for the specific make up of your business. That considers the number of employees, their salaries, as well as their ages. Contribution limits are often based heavily on age as formulas are attempting to give a “defined benefit” in the future.
Younger, high-earning employees will be able to sock away less money into this type of plan. That amount will most likely be somewhere in the neighborhood of $100,000. That number increases to potentially more than $200,000 for those in their 50s and to potentially more than $300,000 for those who are 60 and older.
The biggest surge in new pension plans is coming from thousands of small businesses across the country. Those business owners have been riding the wave of the economic recovery and are seeking more tax-efficient ways to save more of their hard-earned money. Less employees often allows more of the money to flow to the business owner or owners. In many cases, 85-90% of the benefit goes to the owner. At the same time, it can also be a valuable employee benefit and retention tool. Not many of your competitors will be offering their employees a pension plan.
Cash Balance Pension Plans as a Tax Killer
It’s expected that the surge of defined benefits pension plans, of the past few years, will continue as people become more aware of changes to taxation under the TCJA. Most people hate paying taxes. You’d be crazy not to see if this type of plan could save you a bundle come tax time.
On the flip side, big corporate pensions have been dying off and replaced by the cheaper 401(k) plans. For business owners already maxing out their 401(k) profit sharing plans, looking at a cash balance pension plan is the obvious next step. That should be the case for professionals who know about the Rich Person Pension.
For example, a 60-something professional earning $700,000, a year, could set up a cash balance pension plan in order to try and get his income below the $315,000 QBI threshold. He could put around $270,000 into his pension plan on top of the contribution limit of $61,000 to his 401(k) profit-sharing plan, which included the $6,000 catch up contribution. Throw in a few other business expense tax deductions and all of a sudden, that person’s effective tax rate drops below 20 percent. Your specific savings will vary from this hypothetical.
After several years of big contributions to a defined benefit plan, owners often roll their accounts into an IRA. Older workers may do that around retirement whereas younger workers could set up a new pension and start the process again. Moving to an IRA is ideal because it is less costly than maintaining the pension plan. Also, you can typically invest more aggressively on your own than would be prudent within the pension plan. Taxes aren’t due until money is withdrawn from the pension or IRA. Ideally, withdrawals would be made in retirement when you are in a lower, often much lower, tax bracket.
Contributing for your Employees
Don’t worry. Pension plans don’t just benefit the rich by slashing their tax bills. Company employees also get some great benefits. Like most retirement plans, defined benefit pension plans are subject to regulation that must be followed carefully. Most importantly for this conversation are the non-discrimination rules, which require business owners to spread at least a small amount of their contributions to their employees.
Exact numbers will depend on the age and income levels of the employees. While setting up a cash balance plan for a business, it’s common to require a profit sharing around 7.5% of the underlying salaries of its workers. That may prove too costly for some businesses. On the other hand, I’ve found many owners, in the financial position to make such a contribution, who are more than happy to do so.
For the vast majority of those businesses, a wide majority of the benefits are going to the business owners. I’m setting up three plans this week and between 86 and 92 percent of the benefits are going towards the owners. Not too shabby. Those numbers will increase if employees don’t stay long enough to fully vest in the plan. Unvested contributions will be redistributed into the plan and will generally benefit the owners of the business again.
The benefits to high-earning professionals can be huge with a defined benefit pension plan. However, that doesn’t mean it’s the perfect tax-minimizing strategy for every business owner. There are commitments and costs involved with setting up and maintaining those types of plans. The best candidates will have stable and consistent profits. Also, you don’t have to actually come up with the money to contribute right away. Be aware that you need to manage cash flow in order to have several hundred thousand dollars lying around when it comes time to contribute.
Cash Balance Plans Rarely Turned into Lifetime Income
Maintaining a cash balance pension plan costs money and time. Owners will want to make sure that the tax savings outweighs the cost and hassle. It could cost several thousands of dollars to set up and maintain a defined benefit plan. Costs are tax deductible and will vary depending on the size of the plan (number of employees) and assets in the plan. Also, costs will vary from plan administrator to administrator. I’m all for saving money, but this isn’t a place you want to go to the lowest-cost provider who doesn’t really know what he or she is doing. A bad plan design or not following Employee Retirement Income Security Act of 1974 (ERISA) guidelines could mean lower contribution limits or worse, fines.
Many workers dream of having retirement income guaranteed for life. The typical pension would be turned into an income stream, which would last the rest of their lives. While cash balance plans offer this type of lifetime income, very few business owners and their employees end up using the money that way.
The annuity or lifetime income option of a cash balance plan is often more appealing to the typical lower-income worker. That being said, most don’t work long enough for the same employer in order to accrue substantial benefits from their portions of a cash balance plan. Don’t get me wrong. It’s a sizable benefit, but if you only work somewhere for a few years, it won’t translate into a large monthly income benefit.
For business owners, there is often less desire to tie up the money into an annuity or lifetime income stream. Better options are often available on the open market, as opposed to the options provided within the plan. Turning the pension into lifetime income also eliminates some of the future tax planning opportunities, which could lead to higher taxes being paid on withdrawals.
For the most successful business owners, the typical 401(k) will leave them paying way too much in taxes. We’ve had a wave of success helping our highest-earning clients structure cash balance pension plans specifically for their personal financial goals and business needs. Talk with your trusted Certified Financial Planner and CPA to see how much a defined benefit pension plan may be able to save you in taxes each year. It may take a little extra effort, but the potential tax savings make it more than worth it.
These plans are not right for everyone. Make sure to weigh the pros and cons. That being said, they could be a great way to stay on track for financial freedom if you find yourself getting walloped by staggering federal income tax bills or needing to play catch up for retirement. Feel free to reach out and see what else you could be doing to keep more of you hard-earned money.
Aritcle Source : forbes.com
** Disclaimer Required by IRS Circular 230** Unless otherwise expressly approved in advance by the undersigned, any discussion of federal tax matters herein is not intended and cannot be used 1) to avoid penalties under the Federal tax laws, or 2) to promote, market or recommend to another party any transaction or tax-related matter addressed.