As tax advisers and CPAs, one of the most valuable things we can do for our clients is to work together with them. Understanding their details but being able to step back and look at the big picture can present significant tax savings opportunities ranging from loss harvesting among multiple investment accounts to Roth conversion opportunities to retirement planning strategies. This column tells a true story about the advantages of a defined benefit plan where it may not seem an obvious strategy to recommend.
The taxpayer client, Stanley, age 68, is a dentist who resides in a state that collects an income tax. He runs the practice as a sole proprietorship reported on Schedule C, Profit or Loss From Business. He runs a profitable practice with annual net income ranging from $300,000 to $400,000. Other than himself, he employs his spouse, age 64, and an unrelated individual who runs the administration of the practice and whose wages are approximately $50,000 per year. His CPA is responsible for the bookkeeping and tax preparation for both the practice and Stanley's personal return.
For retirement planning, he had a defined contribution plan (Sec. 401(k)) in place with a safe-harbor feature, which allowed him, his spouse, and the employee to defer the maximum allowable to their 401(k)s. As an employee, Stanley's wife had sufficient wages to make the maximum deferral allowable in 2017 ($24,000). In addition, Stanley made a profit-sharing contribution on her behalf of approximately $9,000. Stanley was also obligated to make a profit-sharing contribution on behalf of the unrelated employee, which in 2017 was approximately $3,000. For himself, the current plan allowed Stanley to defer the maximum of $24,000 plus a profit-sharing contribution of $35,000, for a total of $59,000. Total income deferred by Stanley and his wife was approximately $92,000 ($24,000 each as a deferral, plus the profit sharing for Stanley of $35,000, plus the profit sharing for his spouse of $9,000).
Current tax savings: On the surface, this plan is good. Stanley is in a combined federal and state income tax bracket of approximately 40%. Therefore, the impact of the current plan, which resulted in total deferrals for the couple's own benefit of approximately $92,000, yielded a total tax savings of approximately $37,000.
So, what's wrong with this plan? The CPA who maintains the practice's books is not aware of Stanley's overall net worth and liquid assets. Accordingly, she believes that this level of contribution is reasonable and sufficient, as he "needs the cash flow" to live on.
FINANCIAL ADVISER'S PICTURE
A defined benefit plan is a powerful tool, allowing for a deferral of tax significantly higher than a 401(k) or other defined contribution plan. During the year-end tax planning process, the financial adviser took a step back and observed the whole picture, which was as follows:
Stanley's current deferral seemed reasonable and sufficient for his practice's profit level. However, the following key facts indicated a significant tax planning strategy:
- Stanley was in his late 60s.
- His wife was an employee of the practice, and any strategy benefiting Stanley would also benefit her. The other, unrelated employee was younger than Stanley, and her compensation was much lower.
- Unknown to the CPA, Stanley has a trust containing a portfolio of marketable securities worth over $1 million. Therefore, any funds needed to increase the deferral (or fund a defined benefit plan) would not need to come from the dental practice's cash flow, which was used to support Stanley's lifestyle.
A pension expert reviewed the facts and circumstances to determine whether Stanley was eligible to establish a defined benefit plan, where the contributions are based on a variety of factors including the age of the participant, earnings, years of service, etc. He modeled out the plan to compare against Stanley's current 401(k) and discovered a huge opportunity. Implementing a defined benefit plan allowed Stanley to:
- Increase his total contributions to $136,000, up from $59,000 (a $77,000 difference).
- Increase contributions for his spouse to $44,000, up from $33,000 ($11,000 difference).
- The contribution for the unrelated employee increased to $5,700, up from approximately $3,000 (a $2,700 difference). The tax savings to Stanley related to this contribution was over $2,000, so it ended up costing (net out of pocket) approximately $3,700 ($5,700 contribution less tax savings of $2,000).
The bottom line to Stanley was that enhancing his retirement plan by adding a defined benefit plan decreased his combined federal and state income tax liability by over $35,000, approximately 40% of the contribution. Tax deferral by itself is a significant benefit. What makes this strategy even more appealing is that Stanley expects to draw on the defined benefit plan during retirement when he is no longer in practice, expects to be in a much lower tax bracket, and could live in a state that does not levy an income tax.
ELIGIBILITY AND COSTS
A few critical facts determine whether a client is a good candidate for this type of plan. Having worked on this plan and other plans, Todd Heller, Esq., president of Heller Pension Associates Inc., notes just a few:
- Age is important because it affects the contribution. The older the business owner is, the higher the level of contribution should be, depending on income level.
- Income or compensation determines whether there will be a consistent level of income for years to come.
- An ability to make contributions should last for at least a few years. This is not a short-term commitment.
- Ownership of any other business with employees can affect eligibility, due to related-entity rules, which could require all employees from a related business to be covered in the plan.
Heller also points out that these plan designs depend upon the facts of each particular case. There are several methods to structure these designs to substantially benefit small business owners and key employees more than other employees, as long as certain nondiscrimination testing is satisfied. In addition, Heller notes that Sec. 415, which limits the amount that any plan participant can distribute from a defined benefit plan, must be considered when designing and administering these plans.
It is also important to understand that because this is a defined benefit plan, it requires actuarial calculations. Therefore, it is costlier to administer than a defined contribution plan. However, the additional cost is often negligible compared with the tax savings.
The example above teaches the following lesson:
- Looking at a client's overall picture is critical for effective financial planning. Value is added in discovering an opportunity for this type of strategy.
- Working as a team with a client's financial adviser allows for best thinking and out-of-the-box ideas that benefit the client.
- Implementing a defined benefit plan is not always advisable. Certain criteria must be met, and the facts and circumstances must be suitable for the plan.
The tax savings with a retirement vehicle such as this are significant. Additionally, this strategy can be even more advantageous for someone who is a consultant and has no employees. Practitioners should consider and at least discuss it with clients who receive self-employment income, whether or not reported on a Schedule C.
Marianela Collado (firstname.lastname@example.org) is a senior financial adviser at Tobias Financial Advisors in Plantation, Fla.
To comment on this article or to suggest an idea for another article, contact Paul Bonner, senior editor, at Paul.Bonner@aicpa-cima.com or 919-402-4434.