You Could Save Thousands Each Year and Reduce Your Taxes – Here’s How
/Author: Kristin O’Keeffe Merrick
On a recent trip to LA to see some of my super hip clients, I realized that I had reached a milestone with a few of these successful women: they were all just starting to make a great deal of money. As is always the case when making more money, they were also looking for tax mitigation solutions and smarter retirement strategies to match their growing incomes.
Most people who are self-employed think of a SEP IRA as the natural tool for retirement and tax mitigation; however, once you reach a certain income threshold, the SEP IRA doesn’t quite cut it.
Most of us don’t have enough saved for retirement – and most of us think we pay too much in taxes. My clients, who are mostly women in business, have spent years building successful careers but in many cases have also neglected various aspects of their financial lives. As a result, many of them have not contributed enough towards retirement. One of the more exciting parts of my job is to help them find solutions for this very problem, and when I had my first conversations about Defined Benefit (DB) plans, I knew I was on to something.
What is a Defined Benefit Plan and Is It for Me?
A DB plan is essentially a personal pension plan which allows people to make large, tax-deductible contributions that can result in huge tax savings. While the idea of a “pension plan” may conjure up images of the kind of old-fashioned retirement fund that my 100-year-old grandmother is still collecting on (true story), a DB plan is actually a great option for self-employed professionals who want to quickly sock away a lot of money for retirement and reduce their taxes at the same time.
Plans are typically designed for 3+ years for small businesses (sole proprietor, LLC, or corporation) with income over $150,000. These types of plans allow business owners to accumulate a great deal of money to pay a desired “benefit” (i.e., $500,000). Plans are flexible and allow for very high contributions each year. When the plan is terminated, you could potentially continue to benefit from tax-deferred growth on these assets, which allows you to tax plan for the future.
Your contributions may be invested in mutual funds, annuities, bonds, equities, or any other marketable securities that you and your financial advisor select. Investments with low volatility are generally recommended for DB plans.
A traditional Defined Benefit Plan is for people who are typically owner-only, owner + spouse, or family business that can contribute a significant amount of earned income for three years or longer. “A Cash Balance Plan is a type of DB plan for small business owners who have a business with 1-10 employees and are willing to make contributions for their employees for three years or more.
How Does A Defined Benefit Plan Differ from An IRA or a 401(k)?
It is important to understand how a DB plan compares with other types of retirement plans. You’re likely familiar with traditional retirement plans for small businesses like IRA, SEP, SIMPLE or 401(k). These are all defined contribution plans because the IRS defines what the contribution limits are based on earned compensation.
Generally speaking, those of us who have defined contribution plans like a 401(k) or SEP IRA can typically contribute X dollars or X% of earned income to the plan each year. For instance, in 2019 you can contribute up to $19,000 in a 401(k).
With a DB plan, the highest contribution that you can make will be calculated for you based on three key variables:
your income
age, and
number of years until retirement
Someone older can generally contribute more, but there’s a compound interest benefit for those who start contributing at a younger age. Whether you’re a sole proprietor, LLC, or corporation, you may qualify for a large tax deduction from your business income — $100,000 or more each year.
I would like to take a moment for you to appreciate what I just wrote. You could deduct a massive amount of money with this plan.
For example, one of my clients is a writer whose annual W-2 income exceeds $270,000 (which she can use as the basis for a retirement plan). She will now contribute over $100,000 each year to a defined benefit plan, which is deductible from current year taxes. Not only is the tax deduction awesome, but she is also putting a lot of money towards retirement, which will continue to compound and grow over her lifetime. By contrast, if she contributed to a SEP IRA, she would only be able to contribute $55,000 per year.
Can I Use the Defined Benefit Plan as a “Catch-Up” Tool?
I have a lot of clients who are creatives. Many of them have never had access to a retirement vehicle due to the nature of their job and/or industry. This plan can be a great opportunity for them to play catch-up for the years that they weren’t able to contribute towards retirement.
The IRS defines what the benefit limits are for a DB plan. Current regulation defines the maximum annual benefit at $225,000 (hence the name!). Plus, a DB plan offers the highest available contributions and tax deductions of any qualified retirement plan. Think of this plan as a wealth-building and tax savings strategy for self-employed professionals and small businesses.
Taking the Next Step
If you think this plan makes sense for you, talk to your financial advisor or your CPA. You could also chat with a defined benefit expert at a Third Party Administrator (TPA) like Dedicated DB, to better understand the benefits and tax advantages of these plans.
Kristin is a money expert and financial advisor at her family-run firm, O'Keeffe Financial Partners, based in Fairfield, NJ. Kristin has over 17 years of investment experience, having spent the first part of her career in the wild world of foreign exchange and emerging markets at various international banks, and serving most recently as Vice President at Morgan Stanley.
Kristin has chosen to use her background and experience towards the empowerment of individuals, families and small business owners in the challenging world of finance. She is especially passionate about working with women entrepreneurs and executives to provide them with creative financial strategies and solutions. In the past few years, in addition to building her business, Kristin has discovered a passion for writing about money and has contributed to many publications such as Forbes, Girlboss, NY Magazine, Coveteur, Hey Mama, and My Domaine. She has also been featured on the Today Show and the NBC Nightly News. Kristin frequently gives talks about money, investing, and risk management and has spoken at many companies and venues such as Soho House LA, Ludlow House, The Wing, Twitter, Warby Parker, Forbes, Spring Place and the Girlboss Rally.
Kristin is a firm believer in financial literacy for all. She is a strong advocate to narrowing the gender pay gap and increasing the overall wealth of women.
Views expressed are not necessarily those of Raymond James Financial Services and are subject to change without notice. Information contained herein was received from sources believed to be reliable, but accuracy is not guaranteed. Information provided is general in nature and is not a complete statement of all information necessary for making an investment decision. The case study is for illustrative purposes only and individual cases may vary. Raymond James financial advisors do not render advice on tax or legal matters. You should discuss any tax or legal matters with the appropriate professional. Investing involves risk regardless of strategy selected. Links are being provided for information purposes only.
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