At the turn of the 20th century, workers fought for equal rights during the industrial revolution. One of the benefits of that fight was the defined benefit (DB) pension plan. This is the plan you might remember your grandparents had. It was the wonderful benefit where every month the mailman would deliver, without miss, the pension check. Along with Social Security, our grandparents had a very different enjoyment level in retirement.
What has changed? In the early 1970’s, companies figured out that they could switch to 401-K’s and put all the risk on the employee. Along with excessive fees and risk, the amount you can deduct is very small considering what the average American will need to save. In addition, the business owners have been fed information that is usually conditioned by the insurance companies, the mutual fund companies and especially the pension administrators.
There are plans now available where a business owner can deduct over $350,000 a year into a guaranteed income pension plan. These pension plans are set up by insurance companies and mimic the pension plans of 50 years ago. There is a guaranteed income that is not market dependent and has extremely low fees. In addition, this new type of pension option allows the business owner to buy life insurance with tax deductible dollars as well as offering it to employees.
After three plus decades of designing retirement strategies for clients, I often wonder why these types of gems are still buried and clients are not getting advised.
First, the CPA is usually so busy making sure they are keeping your taxes right, they rarely have the time to become retirement plan experts. The financial advisors or brokers are generally given a menu of products to sell and these are usually the most profitable to the company they work for. This type of pension plan is not as profitable long term compared to mutual funds or other types of retirement plans.
Then why are the pension administrators, otherwise known as third party administrators (TPAs) telling their clients about these?
Most pension administrators charge a hefty sum for setting up pension and 401-K plans. When you set up a 412(e)(3) they are either free or cost less than $500. That would lead me to believe that there is not much of a profit for any pension company to set up these types of accounts compared to a 401-K that traditionally costs between $2,000 and $5,000 every year.
One of the other benefits with these programs is that you can still deduct contributions to a 401-K, Profit Sharing plan or a 401-K ROTH, potentially providing a business owner more than a $350,000 deduction each year. This could mean a huge income tax savings for not only the business owner personally but also to the bottom line of the business.
One of the common misunderstandings is starting one of these plans will then cost more because of having to contribute to employees.
If you have employees, there is a contribution required. However, in my experience it is not what you think. First, you get the income tax deduction on the contribution, but more importantly, your contribution and your employees contribution is exempt from Social Security and Medicare. This amounts to 15.3 percent of the first $118,500. Medicare is unlimited and amounts to 3.8 percent on the entire income. In addition, there are wage based trigger taxes such as bracket increases, losses of medical, mortgage, property taxes and other deductions when the income gets too high.
When a complete tax analysis is done, in potentially three out of four cases, the tax savings for the business owners outweighs the contributions to the employees. This gives a net profit to the owner even after putting funds into the employees plan.
The other benefit is your workforce. By having these plans, you hold onto talent longer because you can plan vesting requirements on their plan contributions. With all these benefits, any business owner earning a large income should get a full and detailed tax analysis done to see if this would benefit them.
Lastly, this strategy is best suited for a professional earning a high income with less than thirty employees.
Ken Himmler is president and senior financial planner for H & H Retirement Design and Management, Inc.
