Paying less taxes is imperative for small business owners and employees. 2020 will be a tough year for many business owners, but if your business still generates a good income, you could benefit greatly from having the right retirement plan in place. For top performing companies, it could be a combination of a 401 (k) plan and a defined benefit pension plan, which could save you hundreds of thousands of dollars in taxes. .
Business owners who feel behind schedule when it comes to retirement planning can reduce their tax liability and catch up on their retirement savings by adding a defined benefit pension plan in addition to a 401 (k) profit sharing plan ( k). With potential tax savings of over $ 100,000 per year, I am amazed that more financial advisors are not discussing this valuable retirement planning technique with their clients. I’m going to take a risk and assume that neither your CPA nor your financial planner ever mentioned setting up a defined benefit plan to you.
Proving somewhat of my previous point, a potential client left me a voicemail message saying, “I just read your article on pensions for small business owners; why didn’t my CPA tell me about it? She also missed out on critical opportunities to save more for retirement with a 401 (k) profit-sharing plan. Instead, her tax professional told her that she was making too much money to contribute to a ROTH IRA. Even though she was eligible with her high income, putting just $ 6,000 a year in a ROTH IRA was not going to give her a secure retirement.
In addition, this person had saved over $ 200,000 last year. Most of that money just stayed in her checking account, which meant she couldn’t get a tax deduction and could only earn tiny interest from the bank. These issues will be fixed for 2020 and beyond.
Retirement planning for business owners
Running a business is stressful and cash flow can be an issue most of the time. You continue to reinvest in the business to help it continue to grow. The goal is to eventually cash in, sell the business, and have enough money to finally enjoy life. Or maybe you love what you’re doing and can’t imagine retiring. Not to be a Debbie Downer, but it’s rare that owners can sell their business for enough money to fund what could easily be a retirement of over 30 years.
For those who decide to retire someday, serious savings and, in many cases, catching up is often the case. Lowering taxes can make this process smoother. At the very least, funding a retirement account will help lower your current tax bill or, perhaps, lower your risk of a pandemic (think the next coronavirus) that would bankrupt you.
Pension plans for small businesses
When you own your own business, there are a number of retirement plans to choose from. As a financial planner who works with many business owners, I help people choose the best retirement plan for their specific retirement needs and their business structure. In some cases, we may use Roth IRAs or Traditional IRAs, while others use SEP IRAs. For those who need to save even more (or are looking to minimize larger tax bills), Solo 401 (k) plans are quickly gaining popularity. They have recently become easier to install and less expensive to maintain. 401 (k) profit sharing plans may be the best choice when you’re looking to save around $ 57,000, or less, per year. Business owners trying to save the absolute maximum amount or get the most substantial tax savings may be better served with a 401 (k) profit sharing plan combined with a defined benefit pension plan. .
What is a 401 (k) defined benefit pension plan?
The pension law will allow a company to essentially combine a cash balance pension plan with a 401 (k) profit sharing plan. When these corporate retirement plans are properly structured, business owners can have the ability to put tens of thousands of additional dollars into retirement accounts each year. Did I mention that you get a tax deduction for every dollar you contribute?
What are the disadvantages of a defined benefit pension plan?
For business owners with employees, you will be required to make incentive contributions and offer them a matching contribution, if you really want to make the maximum contribution for yourself. For 2020, a 401 (k) would allow you to set aside up to $ 57,000, plus an additional $ 6,500 if you were over 50. In addition, you may be able to put up to $ 100,000 or more in a defined benefit plan. The exact contribution limits will vary for the pension plan depending on your age, income, employee payroll, and how much you’ve already invested in the plan.
Defined benefit pension plans and 401 (k) plans often have setup costs and may require ongoing record keeping fees. In the case of a defined benefit pension plan, you will likely need to have an actuary review the plan annually to keep it in compliance. While they aren’t cheap, the cost of these types of plans is paltry compared to the value of the potential tax savings.
The biggest downside to pension plans is that you will likely have to commit to minimum funding levels for about five years. The minimum contribution levels are linked to the profits of your business. If business goes down, your engagement will also be lower.
Keep in mind that your employees’ contributions are also tax deductible. With good planning, a large portion of the financing can go to the owner. The plan I funded this week had 90% of the company’s money going to the owners of the business. These percentages will vary depending on the size of the company, the payroll, the number of employees, etc.
Who Benefits Most from a Defined Benefit / 401 (k) Combo Stack Pension Plan?
Self-employed people or high-income small business owners are attracted to these types of plans. Higher incomes lead to more tax obligations than these people wish to minimize. Likewise, the more you earn, the more you will need to save for a comfortable retirement. With a combo, you could potentially set aside $ 200,000 per year, before tax, maybe even more. These plans work well for family businesses or spouses who work together.
If you are looking to save less than $ 57,000 per year, a typical 401 (k) plan may be the best option. Keep the 401 (k) / Defined Benefit Pension combo on your radar if you’re looking to save more now or in the future. Your CPA or financial advisor probably won’t recommend it.
Assuming the top 37% tax bracket, maximizing this plan could save you over $ 55,500 in federal taxes. Additionally, your state tax bill will be reduced if you live in a state with income taxes. For those trying to stay below the new 20% tax break for passed income caps, it can help in this regard as well. It’s not what you do, it’s what you keep. With that in mind, don’t make strategic tax planning something you only do once a year. The cost of poor tax planning is too high.
Using the 401 (k) Stack pension to further benefit from the 20% tax break
You may have heard of the new 20% tax break for flow-through entities, which began in 2018. Some of the more common examples include Sole Proprietorships, S Corps, LLCs, and Partnerships. If you operate a flow-through entity that would be considered a “service,” the 20% deduction will gradually disappear as your income increases. For single filers, this elimination starts at $ 163,300 in 2020. The numbers are a bit higher for married couples, with the elimination starting at $ 326,600.
Look at it this way; your contributions to the pension plan will entitle you to a contribution deduction. These contributions can also help lower your income threshold, noted above. If so, you will be able to maintain the 20% tax break. You can either earn less money or, in some cases, write yourself a check in the form of 401 (k) and pension contributions. Which would you prefer?
If you’re interested in a defined benefit plan, ask your current financial advisor and CPA if they can help you set up this valuable tax-saving plan. If they aren’t able to help or don’t know how to do it, consider finding a Certified Financial Planner who is an expert in defined benefit pension plans and able to help you invest for the retirement you deserve. .