Small business clients who have seen their businesses return to profitability following the economic crisis of the past few years may have secured their continued viability, but many have done so at the expense of personal retirement security. As a result, a vast portion of the baby boomer population is now struggling to play catch-up. Unfortunately, traditional retirement savings vehicles, with their strict contribution limits, often are not enough to replace years’ worth of lost savings. For many baby boomer clients who own small businesses, a new strategy that combines a defined benefit plan with elements of a voluntary 401(k) plan can allow the client to save more than ten times as fast as a traditional plan, with dramatic tax savings that your clients will have to see to believe.
The Pension Protection Act of 2006 created a powerful new savings tool for small business clients looking to increase their savings rate while maintaining some of the flexibility of a 401(k) plan. The DB(k) plan combines elements of a defined benefit plan — which allows the employer to set aside pretax dollars based on age, salary, and employees’ ages — with a safe harbor 401(k) plan.
Because contributions to a defined benefit plan do not count toward the 401(k) contribution limit — $17,500 in 2013, plus a $5,500 catch-up for clients aged fifty and older — clients are still able to take advantage of a 401(k) strategy. The employer is required to contribute a certain percentage of employees’ salary to the defined benefit portion of the plan, and enrollment in the 401(k) component must be automatic with at least a 4 percent salary deferral rate.
The defined benefit portion of the plan, which bases contribution limits on age and salary, assigns a greater portion of the benefit to clients nearing retirement age, increasing the value of the strategy for baby boomer clients. Further, because the contributions are made with pretax dollars, heavily funding a DB(k) plan can actually bring the client into a lower income tax bracket, potentially allowing the client to avoid the new limits on deductions and exemptions for high income taxpayers in 2013.
Who Benefits Most from the DB(k) Strategy?
For baby boomer clients with relatively high salaries (generally, at least $200,000 per year), the savings potential is dramatic. These clients can often contribute over $225,000 per year in pretax dollars, building a plan with more than $2 million in assets in about ten years.
Small business clients who are nearing retirement age and operate businesses with relatively few employees who are substantially younger will realize the greatest benefit from use of the DB(k) strategy. First, the plan will allocate a larger percentage of the plan assets to the older participants, so a client with younger employees will gain a more substantial personal benefit, while the remainder of the plan assets will be set aside to grow for the benefit of employees. Further, the client will be required to contribute on behalf of each employee; fewer employees reduces this liability.
A client who has the flexibility to allocate a greater portion of the business’s profits to his own salary is also in a strong position to benefit. If the client is able to characterize company distributions as salary, rather than as dividends or S corporation distributions, for example, that client will be able to contribute more to the defined benefit plan.
While a client with a substantial number of employees who are also nearing retirement age may not be able to realize such a dramatic benefit with the DB(k) strategy, for some small business owners, no other savings vehicle will offer a more powerful catch-up tool to ensure retirement income security.
For previous coverage of strategies for maximizing retirement savings in Advisor’s Journal, see Multiplying Deductible Familial IRA Contributions.
For in-depth analysis of the defined benefit plan requirements, see Advisor’s Main Library: E—Defined Benefit Plans Explained.
Your questions and comments are always welcome. Please contact the Panel of Experts.