Advanced Retirement Plan Options for Self-Employment Income

As we wrote in the previous post, it’s very easy to set up either a Self-Employed 401(k) or SEP IRA to defer income from tax and increase retirement savings.   

As we discussed in that article, SEP and Self-Employed 401(k)s are advantageous in that they typically cost very little to operate. They also offer the maximum flexibility in that there are no minimum contribution requirements for self employed individuals.  In other words, if you have a bad income year, you don’t have to fund either plan.  You can likewise terminate either plan at any time for any reason.

While this $62,000 401(k) deferral figure is significant (or $56,000 for SEP IRAs), some self- employed individuals with substantial income may want to defer even more than the maximum allowed via SEP or Self-Employed 401(k)s.

Under the appropriate circumstances, high-income earners can potentially defer several hundred thousand dollars of income from tax above and beyond the $62,000 maximum 401(k) contribution via a separate retirement plan — a Defined Benefit Pension Plan “DB Plan.”

While this sounds almost too good to be true, DB plans are commonplace and have been used by some of the most recognizable names in America – including Jeb Bush. 

According to the Wall Street Journal, Jeb was able to defer an average of $350,000 per year for 5 years (ending in 2015) combined total via a DB plan + 401k/Profit Sharing Plan.

So what is a DB Plan?

In its simplest form, a DB plan is a pension plan. According to the IRS, a company of any size may establish a pension plan for its employees.    This of course includes companies consisting of just one individual.

Corporate pension plans are almost non-existent these days but were the norm for previous generations. So, just like your parents or grandparents may have had a pension when they retired, your highly profitable one-person business can set up a pension plan for its employee (you).  

The way that pension plans are structured is that they provide for an annual retirement benefit – the max is $225,000– at a specified future age –typically age 65. 

From a tax standpoint, in order to be able to fund an annual pension of $225,000 for yourself at age 65, you’re going to defer/contribute a significant amount each year to the pension plan.   This is especially true if you’re close to age 65.  The best part, all these annual contributions – which may be significant — are tax deferred

Once the funds are inside of the DB Plan, you can invest 
the proceeds in marketable securities to fund the future pension.

One of the best parts about these plans is that you may not have to actually take a future pension. You can structure the DB plan to allow you to take a lump sum distribution – via IRA rollover – at retirement age or plan termination.  In practice, the ultimate rollover of a DB plan into an IRA is usually what happens to these self-employed DB plans.

The caveat to DB plans is that they are complex.   Before making a decision about a DB plan, you should involve the help of your CPA, attorney, and financial advisor. Without getting too much into the weeds, here are some considerations:

  1. These plans aren’t cheap – the upfront and ongoing administrative costs can be several thousand dollars each. The reason these plans are costly is that they are complex – they involve an actuary and a third-party administrator.  You should consult with your trusted advisor about the economic benefits versus these upfront/annual costs.

  2. Unlike a SEP or Self-Employed 401(k), these plans aren’t flexible.  Once you decide to set up a DB Plan, you’re basically committed to funding it for several (e.g., 5+ years).  There are exceptions for unforeseen circumstances.  However, if your revenue is off one year, you could still be required to come up with money to make a pre-tax contribution to the plan.  As such, these plans are only suitable for businesses with consistent cash flows.

  3. These plans tend to work better for older people (age 50+). If you are 55, there is simply less time to fund a $225,000 annual pension that’s set to start at 65.  So you’d necessarily have to put more money in the DB Plan if you’re older.  If you’re younger, time and compounding should conceivably mean that less contributions are required.  As such, age 50+ is when you usually see the high, tax-deferred annual contributions (e.g., ~$300,000).  That being said, we’ve seen these plans economically still work for people in their 40s or even 30s, yet at much lower annual contribution amounts.

  4. Prudent investment management inside of the plans is paramount.  Each plan has a target annual return.  If the plan’s actual return is significantly lower, than the funding requirement could be higher than expected. On the other hand, if the rate of return is higher than the target, then the funding could be lower than expected (resulting in a lower tax deferral).

A last thing to note – if your spouse is active in your business, and you’re both in in the latter stages of these careers, you may both be eligible to save/defer a substantial amount into a DB Plan.

This piece is not meant to be exhaustive – and you should absolutely work with professionals in setting one of these plans up. If you establish a DB Plan understanding all the pros and the cons at the outset, and the plans are effectively managed, they can be great financial planning tools.

https://www.wsj.com/articles/jeb-bushs-pension-cut-his-taxes-1435858574