By Richard K. Newman, CPA
Newman + Cohen Financial Management
The 2001 tax law has gone into effect, with its higher limits on retirement
plan contributions. Most of the media attention has been focused defined-contribution
(DC) plans...
401(k) plans now permit salary deferrals up to $11,000
per year, rising to $15,000 a year by 2006, People age 50 or older can contribute
an extra $1,000 this year, $2,000 in 2003, going to $5,000 in 2006.
Profit-sharing plans now permit contributions up to $40,000
per year But defined-benefit (DB) plans may permit even larger deductible
contributions. If you are over age 50 and highly compensated, six-figure
contributions may be allowable.
Defined-benefit plans are traditional pension plans. They're designed to pay
retirees a certain amount, based on earnings and length of service. To deliver
the promised pension, sizable amounts have to be accumulated in the plan.
Example: Joan Jones qualifies for a $100,000 annual payout from
her defined-benefit plan when she retires. To make these payments, her employer
will have to contribute and accumulate in the plan $1 million, $2 million,
or more, by the time she retires. (Various assumptions will determine the exact
amount.)
Higher and higher
Several provisions in the 2001 tax law boosted defined-benefit plans...
Higher limits. The maximum benefit payable under a defined-benefit
plan is $160,000 per year. That's up from $140,000 in 2001.
This limit will increase
with inflation, in $5,000 increments. Thus, when inflation has risen by a cumulative
3.125%-probably in 2004- the PB limit will hit $165,000. Ever-higher ceilings
are likely.
Key: The higher the DB payment, the more that can
be contributed (and deducted) currently.
Caution: Your payment
from a DB plan can't exceed your peak earnings.
Earlier retirements. Under prior law, the $140,000 maximum PB payment
was reduced if you retired before age 65. Now, you can retire as early
as age 62 and get the maximum benefit.
Indeed, if you retire after age 65, your PB payments
can exceed the current limit.
Again, if you plan to retire at age 62 rather
than age 65, higher contributions are necessary.
Greater compensation. As is the case for all retirement plans, compensation
up to $200,000 may be taken into account for purposes of determining how
much you can contribute. Last year, the upper limit was $170,000.
The limit will increase
in $5,000 increments, with inflation. This number likely will reach $205,000
in a year or two.
Larger deductions. There are actuarial limits on deducting contributions
in excess of a plans current liability These limits have been eased and
will disappear after 2003.
Bottom line: The interaction of these new
rules allows much larger DB contributions now.
Example: Ted Peters,
58, earns more than $200,000 per year. He wants to create a DB plan. Under
the 2001 rules, he could have contributed about S225,000-this year, his deductible
Contribution will be more than $290,000.
DBs for self-employeds
If you're self-employed, you can create a defined-benefit plan for yourself.
Generally if you're over 40, you'll be able to put more into a DR plan than
the current $40,000 ceiling for DC plans.
The older you are, the greater the advantage of a DB plan over a DC plan.
For employers: If you run a business or professional practice,
you can adopt a DB plan. In such cases, you must contribute for your employees
as well as for yourself.
Loophole 1: It is permissible to set up a vesting schedule for
DB participation. Doing so will reward longtime employees but not short-timers.
In fact, employees who leave the company will forfeit unvested benefits, and
such forfeitures will reduce the amounts your company will have to contribute.
Loophole 2: You can restrict employees with less than two years
of service, union members, non-US citizens, and part-time workers from being
eligible for the DB plan.
On the other hand, a DB plan can help motivate loyal employees. Considering
the uncertainty of stock market returns after a two-year bear market, the security
of a DB pension might be very appealing.
DB plans generally work better for company principals if they are much and
more highly paid than rank-and-file employees.
Example: If you're in your 50s, you might make a six-figure
contribution toward your own pension, yet contribute only a few thousand dollars
for your 20-something receptionist.
Bonus benefit: You might structure a DB plan that will pay a
benefit to your surviving spouse as well as to yourself. Again, that may tilt
contributions in your favor, especially if most of your employees are unmarried.
Two for the money
If you decide to adopt a DB plan, you have two options...
Traditional DB plan. For this type, you may invest
in a range of securities. Investing in bonds reduces the risk your plan will
lose money Also, by investing in relatively low-return bonds, you increase
the amount you'll have to contribute (and deduct) in order to reach your
accumulation targets.
412(i) plans. These plans must be funded with
insurance products. Often, contributions are invested in fixed annuities.
Which plan is better for you? That depends on two factors...
Age. Traditional DB plans may allow larger contributions
for people in their 40s while 412(i) plans may be better if you're in your
50s or 60s.
Size of company. With no more than five employees, a 412(i) plan may
result in greater skewing of benefits to you, as owner-employee. With six to
10 employees, a traditional DB plan may work better.
Caution: Larger
companies may find it very expensive to provide a DB plan for employees.
Shifting gears
Your company may already have a DC plan in place. Indeed, as long as you were
in your 20s and 30s, such a plan was the better choice.
What do you do now, if you want to adopt a DB plan? Two choices...
Freeze the old DC plan. You would make all ongoing
contributions to the DB plan. The DC accounts may continue to grow, until
they're ultimately distributed to individual participants.
Maintain
two plans. In some cases, it may be possible to contribute
to a DB and a DC plan, increasing the tax shelter.
Check with an employee benefits
pro to see if it's worthwhile to sponsor both plans.
Sponsoring disadvantages
DB plans require actuarial updates each year, which may be expensive. You'll
have to determine whether the extra tax shelter you'll receive will be worth
the price.
DB plans require substantial funding, year after year. Thus, they're best
suited for businesses and professional practices with dependable income.
If your business is volatile, you may not want to be required to make a large
contribution in a bad year It's true that DB plans can be amended, if necessary,
but extra expense and effort will be involved.
Bottom line:
The best candidates for DB plans are older professionals
and business owners who have substantial incomes, year after year, and a much
younger work-force with high turnover.
Professional practices with few or no employees may reap benefits from DB
plans.
