Your CPA probably won’t tell you about this. Your financial advisor probably won’t either.
It’s not because they are incompetent. It’s just because most professionals don’t practice tax planning.
When most people think of a defined benefit plan they think of a large company pension. But this is simply not the case.
Defined benefit plans can be successfully used for small businesses as well. In fact, this is why we call them one of the best kept tax secrets.2020 Quick Navigation
- How are defined benefit plans taxed?
- Pass-through businesses and the 20% tax deduction
- Tax benefit and deduction limit
- Tax strategy candidates
- Are contributions to defined benefit plans tax deductible?
How are defined benefit plans taxed?
Defined benefit plans are traditionally favored by business owners with high incomes, like physicians and attorneys. If a business owner and spouse (who works in the business) contribute to a plan, they could enjoy up to $600,000 in tax deductions and retirement contributions. This becomes especially important considering the new tax laws passed in 2017 (more about this later).
Contribution limits increase as employees approach retirement. This is possible due to high contributions made towards the plan. Another defined benefit plan advantage is that they can be combined with other plans like a 401(k) and profit sharing plan that can maximize contributions and tax deductions.
Employees may also prefer a defined benefit plan. Employers (or plan sponsors) do all the tasks. This includes the obligation to make contributions, assuming investment risks, and completing all plan responsibilities. The sponsor can, however, appoint a third-party administrator (TPA) to help with administrative responsibilities while it concentrates on plan investments.
Pass-through businesses and the 20% tax deduction
Pass-through business owners (including partners, S-corporations and sole proprietors) have a lot to smile about with tax reform. The 2017 tax reform offers significant tax savings to qualified business owners. Pass-through businesses can now take a 20% deduction from qualified business income.
However, the rule will not apply equally to all business owners. It restricts certain service businesses like consultants, accountants, physicians or attorneys if their taxable income is over a specified limit.
If over the threshold, they may pursue additional tax strategies to lower their taxable income. This is where the deduction can really help.
Professional service business owners often realize that setting up a defined benefit plan is one of the best ways to remain below the specified threshold. The threshold is taxable income of $157,500 for single filers and $315,500 for married filers.
The 20% deduction limit is gradually phased-out for personal service owners until a complete phase out of $207,500 for individual filers and $100,000 for married filers.
Tax Benefit & Deduction Limits
Contributions under a defined benefit plan can be as high as $300,000, depending on age and income. In contrast, 401(k) plans allow a contribution up to $57,000, plus an extra $6,500 for individuals 50 years and older. Combining a defined benefit plan with a 401(k) and profit sharing plan can result in even larger tax deductible contributions.
A sole proprietor with a defined benefit plan can even benefit under the 20% tax deduction. Partners and business owners in an S-corporation, therefore, have to split the tax deduction benefit between the owners. Based on non-discrimination testing, business owners will typically have to contribute 5% to 7 1/2% of pay for other company employees.
Defined benefit plans can be combined with other strategies including charitable contributions to further reduce business taxable income. Accordingly, business owners should seek to combine a variety of strategies to make sure they qualify for the 20% tax deduction.
Tax strategy candidates
Defined benefit rules require high business income or high employment income. Due to restrictions and limits applied to the 20% tax deduction, high contributions under a defined benefit pension can be a solution. The following may, therefore, benefit the most from a defined benefit plan tax deduction:
- Physicians, lawyers, CPAs, financial planners, investment advisors, consultants and engineers;
- Business owners who have profitable businesses and sustainable, consistent income;
- Business owners over the age of 50 who may have minimal retirement funds;
- Owners who would like to include life insurance;
- Companies who desire to hire and retain critical employees; and
- Other high-income professionals who desire significant tax deductions.
Defined benefit plans are a highly effective tool for tax planning. However, make sure the business owner is educated on the pros and cons of the plans.
In addition, adequate cash flow should be available to fund plan contributions up to the limit. A third-party administrator should be used to ensure that administrative tasks are accomplished.
How to maximize defined benefit plan tax benefits:
- Calculate marginal federal tax rate
Take a look at your prior year tax return and analyze your current year tax liability with your CPA. Consideration should be made to both your federal and state tax rate. If your rate is increasing, a plan will make more sense to set up.
- Consider your funding range
In the first year we often establish a flat dollar amount. But this can also be a variable contribution. Most clients will select an ongoing variable amount that will provide a wide enough range.
- Review employee census
Don’t forget that you will have to make plan contributions for any qualifying employees. But our goal is always to get at least 85% to 90% of the overall contribution allocated to the owner.
- Examine your cash position
Even though your tax situation may dictate a large plan contribution, you might not have the cash position. You might be thinking of purchasing equipment or looking to retain cash in the business.
- Execute funding goal
Once your are comfortable with your funding range, review with your tax advisor and administrator. Remember that your contributions are required by the date you file your tax return..
Are contributions to defined benefit plans tax deductible?
The goal of every retirement plan is to maximize retirement savings while saving money on taxes. Defined benefit plans are no different. Your defined benefit plan tax deduction will vary based on your tax bracket and contribution size.
Section 401(a) of the Internal Revenue Code specifies defined benefit pension plans as qualified plans. Accordingly, S-corporations, sole proprietors, and C-corporations receive a tax deduction for contributions made to the pension plan.