Wealthy & successful business owners can use pension plans to save significant taxes, and now even more so post-tax reform.
How Does it Work?
Pensions, or defined-benefit plans, can be used by professional service businesses like doctors, lawyers and wealth managers, to deduct hundreds of thousands of dollars a year. So not only are they reducing taxable income, building their retirement and wealth, but they are now able to use this strategy to plan around the new pass-through entity deduction limitations.
The IRS says those that are in a specified trade or business (including accountants, lawyers, doctors, high value consultants and the like) can’t take advantage of the new 20% pass-through entity deduction if they earn over a certain threshold; $315,000 married filing joint or $157,500 if they’re single. This is driving professional service business owners to find ways to drive income below these levels in order to take full advantage of the benefits of tax reform. One tax planning tool that we have found can work well is implementing a well-designed pension plan.
Businesses make required contributions according to a set formula and manage all investments together, frequently guaranteeing a set return. The annual contribution limits are much higher than a traditional qualified plan. For example, the 401(k) annual limit of $18,500 individual contribution, or $5,500 for a traditional IRA. Generally speaking, employees up to their early 40’s could be able to contribute $100,000 or more, and those closer to their 60s over $300,000 per year. Many larger firms and businesses already have these in place, but it is becoming more and more attractive for smaller business owners.
Who Should Consider This Strategy?
This isn’t a one-size-fits-all strategy for business owners. These types of qualified plans require a commitment of several years of pension contributions, so employers must be confident of steady profit before signing up. Additionally, the costs of setting up and administering these plans can be high. A small business with 10 employees could be looking at a one-time set-up fee of at least $6,000 and annual fees around $9,000, in addition to the costs of designing the tax plan that may include this strategy. So, it is important to thoroughly evaluate the potential tax savings, as well as have a group of well-qualified professionals design the plan, manage the plan, and perform annual compliance testing and reporting.