Around a year ago, I left a full-time job for the uncertainties of freelance writing. Along with secure employment, I said goodbye to a 401(k) plan. I assumed that once I settled into my new work, I would explore the variety of defined-contribution retirement plans available to the self-employed. But my accountant had a different idea. Instead of an off-the-shelf individual retirement account or Keogh, he suggested a traditional defined benefit plan. It would guarantee a fixed monthly pension as long as I stashed away enough each year to meet the target. And the tax savings would be enormous.
While I didn't expect to gross more than $65,000 in my first year of working for myself, my husband's income seemed stable. So my financial advisor, Mary A. Malgoire, president of The Family Firm Inc. in Bethesda, Maryland, did a long-term cash-flow analysis of our household income and expenses. She decided we could afford to commit a substantial portion of my after-expenses income to a tax-deferred defined benefit plan. True, my yearly contributions would be higher than if I used any of the available defined-contribution options--at least $20,000 in the first year. But because the contributions would be fully deductible, I would significantly reduce our joint tax bill. Even after paying set-up and annual fees to an actuary, it seemed a no-brainer.
Although corporate America has shifted en masse to defined contribution retirement plans, a lot of Baby Boomer entrepreneurs, consultants, and other free agents are going in the opposite direction as they reach their peak earning years. A business owner close to retirement can easily sock away, tax-deferred, more than $100,000 a year under a defined benefit plan, compared with a maximum of $30,000 under the most generous defined contribution plan. And last year, Congress added another incentive. Until Jan. 1, 2000, the Internal Revenue Service had imposed strict combined limits on contributions and benefits accrued by anyone participating in both types of plans. But those limits have now been removed, allowing individuals to make maximum contributions to both types of plans.
An individual doesn't need an incorporated business to establish a defined benefit plan. Lee Bachu of Krish Actuarial Consultants in Greenbelt, Maryland, which set up my plan, says individual defined benefit programs are especially popular with professors. "They'll get a W2 from a university, but we can place their outside consulting money into a defined benefit plan," she says.
At the advice of their accountant, William Dietch, 54, and his business partner, who run a commercial lending firm in Bethesda, set up a defined benefit plan with Bachu's help several years ago. Despite years in the real-estate development business, the two had never participated in a tax-advantaged retirement plan. Dietch chose the defined benefit route when he realized he could make "significantly higher contributions than I could with any other plan." He adds: "It's the answer to the prayers of people in our situation--older people without substantial retirement funds who are trying to build up something quickly."
Though the advantages of defined benefit plans are clear, there are numerous and complicated steps you'll need to follow to get a plan going. For one thing, you'll need to select a custodian, say, a broker or mutual fund family, to establish a defined benefit account through a trust document, using the name of the plan as the account name. The client must apply for an employer identification number, which then becomes the trust's ID number. The employer is the plan sponsor and, in most cases, the trustee. However, your client can choose someone else as trustee.
You will also discover that even clients of the same age and income may end up with very different plans. So before recommending a defined benefit plan to a client, check first with an actuary who specializes in pensions to get some idea of the income a client could shelter. Many advisors are under a mistaken impression that a client, from the get-go, can defer one's entire income or close to it. But it doesn't work that way.
Actuaries say that in 2000, under a defined benefit plan, a sponsor could fund a benefit that was up to 100% of compensation, or $135,000, whichever is less. The upper limit rose to $140,000 this year, however.
A person whose net pay is $90,000 can shoot for an annual $90,000 lifetime retirement benefit or a specified percentage of it, and then make yearly contributions to meet the target. But remember that the benefit is based on the average of the sponsor's highest consecutive three years of compensation. That means a client must develop a compensation history before coming up with a benefit target. And compensation is not gross income, but earned income reduced by business expenses and the pension contribution.
Let's take a person who grosses $150,000 in the first year and has $20,000 in expenses. After considering a number of factors, an actuary decides the participant should make $60,000 in pension contributions, which leaves a net compensation of $70,000. If in the second and third years, the net compensation is set at $80,000 and then $90,000, the average compensation upon which the benefit is based is $80,000.
Contributions in the future will be based on that three-year average. If gross income drops to $90,000 in the fourth year, the client could still make contributions to meet the $80,000 benefit target--perhaps using nearly 100% of earnings to do so. If gross income rises, an actuary can recalculate upward the three-year average, as well as the contribution. Or the actuary may decide to keep the benefit target at $80,000, and change other assumptions that would allow the participant to boost contributions. Actuaries charge between $1,200 and $1,500 to set up a plan, plus $750 to $1,000 a year to make adjustments and file required reports with the IRS.
The trick for an actuary is to figure out how to maximize contributions without throwing a plan out of balance. In calculating contributions and benefit targets, an actuary uses a formula that considers a variety of assumptions, including a client's age, number of years left until retirement, expected annual income until retirement, and an investment rate of return of about 6% or 7% annually. An actuary also will consult a government-approved mortality table to calculate life expectancy. "By trial and error, I try to come up with the benefit that produces the contribution a person can afford," notes Bruce Marotta, president of ALI Actuarial and Retirement Plan Services in Port Orchard, Washington.
One way to boost yearly contributions is by shortening the life of a plan. High income business owners who start up a plan in their late 50s or even 60s could end up sheltering upwards of $150,000 a year. "You're allowed to play catch-up because of your age," says Jane V. King, president of Fairfield Financial Advisors Ltd. in Wellesley, Massachusetts. In fact, for middle-aged entrepreneurs, defined benefit plans allow participants to shelter considerably more than defined-contribution plans.
A SEP IRA, for instance, allows an individual to put aside, tax-deferred, 15% of compensation, with a ceiling of $25,500. A Simple IRA allows for a contribution of up to $6,000, while a 401(k) allows deferrals of up to $10,500 in pre-tax income. With a Keogh, individuals can contribute 25% of compensation, up to a maximum contribution of $30,000.
King maintains a defined benefit plan can beat those numbers. In her example, Sue is 35 years old, and Sam 55. Each earns $160,000 annually and plan to retire at 65. Each has a Keogh. Assuming contributions earn 8% a year, Sue would have $3.4 million at retirement, while Sam would have about $434,600. But if Sam, instead, contributes a tax-deductible $89,170 a year to a defined benefit plan, he would fund an annual retirement benefit of $121,333, with a lump-sum value of about $1.2 million.
Not for Everyone
Because participants are obligated to fully fund a plan to meet its benefits, Malgoire says such plans work best for those whose income and expenses don't fluctuate dramatically. If the initial benefit target is set too high, a client could face a quandary when the kids' college bills come due. "We look at the pattern and trend of cash flow over the foreseeable future," she says. "Though you can always adjust the plan, you really need to be able to make a commitment for five years."
For this reason, you may want to steer younger entrepreneurs away from defined benefit plans. For instance, a high-income 30-year-old who plans at age 65 to take a benefit of $117,000 (the maximum $135,000 prorated for retiring two years earlier than the full Social Security retirement age of 67) would be allowed to make an annual contribution of just $8,075, according to Kenneth D. Anderson, consulting actuary at Kenneth D. Anderson Co. Inc., a pension-consulting firm in Concord, Massachusetts. Compare that with the 25% of compensation--up to $30,000--the same individual could place into a Keogh.
Business owners should also think twice if they intend to hire employees or sell their companies in the near term. Federal rules require that if a business owner is covered, a certain percentage of employees must be covered too. Once that happens, the plan must follow strict contribution and vesting schedules, pay yearly premiums to the federal Pension Benefit Guaranty Corp., and comply with fiduciary standards.
Sole proprietors have more leeway. They vest immediately. And they're not locked into any particular benefit or contribution. Benefit targets and contribution levels can be readjusted with little hassle.
It gets tricky at tax time. If a sponsor is filing a tax return by April 15, the accountant must figure out income and all business expenses way before then. The actuary will need those numbers to come up with the contribution that the accountant will then enter as a deduction on the tax return. Also, the tax return cannot be filed until the contribution is made. The actuary will then file necessary reports with the IRS by July 31.
An actuary can lower or raise the contribution levels by changing assumptions. Contributions, for instance, can be nudged up by lowering the interest rate on pension assets. Or the actuary could amend the plan by changing the projected retirement age. The actuary can also amend a plan by changing the benefit formula, or can "freeze" a plan for several years.
An individual can terminate a plan at any time, say, when she takes a job with another employer. To terminate, the individual pays a fee to the actuary to file papers with the IRS. The participant would be eligible for benefits accrued up to that point. But amending a plan too often, or terminating one, can raise red flags with the IRS. "If you change the goals on a regular basis, the IRS may not look at it as a permanent plan. And if you terminate it for no good reason after a year or two, it can be viewed as a tax sham," says Michael Callahan, president of PenTec, a pension consulting firm in Cheshire, Connecticut.
If the IRS decides that a plan is simply a tax-avoidance scheme, it could disqualify the plan, and the client would have to pay taxes on the deferred income, plus penalties.
Participants can withdraw the full benefit at 65, the current Social Security retirement age. A person can decide to set a retirement age at 60, or even earlier. But if that sponsor starts withdrawing benefits before the full Social Security retirement age, he or she will have to accept a benefit that is prorated for each year of early withdrawal. That's because a younger retiree has more benefit years to fund.
At retirement, the sponsor has several options. A person can keep the plan intact and draw the yearly benefit. A client could buy an annuity that guarantees an annual lifetime benefit based on the lump-sum value. That's fine for those who don't want to deal with the vagaries of the market. The drawback is that the benefit would end at the retiree's death or at the death of a spouse. Most financial planners recommend that the retiree roll the lump sum into an IRA. The retiree can withdraw the money at will and pass the remainder to heirs.
Sole proprietors who want to avoid worrying about the gyrations of the stock market can purchase a defined benefit plan from an insurance company. The 412(i) plan is a qualified retirement plan funded entirely with guaranteed insurance-company contracts. This type of plan doesn't require an actuary. According to Lance Wallach, a financial planner in Plainview, New York, an insurance company will calculate a tax-deductible contribution to fund a known retirement benefit. Wallach says a business owner can make bigger tax-sheltered contributions than under traditional plans because the company uses a lower rate of return, perhaps as low as 3%, to make funding projections. However, commissions and management costs can be higher than fees charged by the actuary. And clients would be passing up the benefits of portfolio diversification and the chance for bigger growth in their pension assets. But whichever route a self-employed person takes, for those in the highest bracket, the chance to wipe off thousands of dollars from one's tax bill each year could become a form of investment that's too enticing to pass up.