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With business income comes the inevitable: income taxes. Setting up a defined benefit plan is a smart choice for high-net worth, high-taxable income business owners wanting to take steps to minimize income taxes and protect assets and personal wealth from judgment creditors—all with upfront IRS approval.

DC Plans vs. DB Plans

Qualified pension plans, known as “qualified” because contributions qualify for a current income tax deduction, come in two general styles, Defined Contribution (DC) and Defined Benefit (DB).

Defined Contribution plans include 401ks and simplified employee pension (SEP) plans. The account holder defines the contribution that is made to the plan. This year, the maximum contribution is 25 percent of payroll not to exceed $52,000 for any one participant. However, the amount that the account holder receives in the future is unknown; it depends on how much is contributed each year, how many years monies are contributed, and what the monies earn on investments.

The traditional plan is the Defined Benefit plan. Think back to the previous generation’s employees, who would work for a company for 30 years and could choose to retire on 75 percent of their salary. The company’s plan defined the benefit that was paid at retirement.

At one time, DB plans were the cornerstone of one’s retirement. Lately, they have fallen out of favor after taking on negative connotations due to the financial crisis and fears of “underfunded” or “unfunded” liabilities. However, the criticism lies mainly with DB plans sponsored by a state or county government or a large company listed on the stock exchange. Most of the larger companies have replaced their DB plans with DC plans.

However, the DB plan remains a fantastic program for a closely-held business or professional practice. Why? Because the small business is run by focused and driven individuals. DB plans for the building industry sector are not about employee benefits or “retirement” as much as they are about the income tax deduction, the tax-deferred growth, the asset protection under the Employee Retirement Income Security Act of 1974 (ERISA) and the fact they are approved, in writing, with a Favorable Determination Letter from the IRS.

For these entrepreneurs, DB plans can be an ideal vehicle for the business owner to keep a larger share of his or her hard-earned dollars.

However, many businesses and professional practices have not implemented any type of qualified plan because they hold on to the following common set of misconceptions.

  • “A plan will cost too much to administer.”
  • “My employee costs will kill me.”
  • “I’m already paying salary, sick pay, vacation pay, matching Social Security and Medicare; paying into worker’s compensation, unemployment and this will add to my overhead.”
  • “My employees don’t or won’t appreciate it.”
All of these statements are untrue. A custom-designed DB plan can provide substantial tax benefits to the business or professional practice owner without any worst-case scenarios happening.

DB Advantages

Those generating more than $200,000 a year in taxable income should consider setting up a pension plan—even if the individual already has existing “retirement” investments, such as a 401k, IRA or the like. The DB plan makes perfect sense for the business owner who wants a larger annual tax deduction, and it can be added to any existing 401k plan.Key benefits:

Higher annual contribution limits. Like a 401k plan or an IRA, DB plan contributions are income tax deductible on the business’s or professional practice’s tax return. The key difference is that higher tax-deductible contribution limits are allowed in DB plans. The maximum deductible contribution is around $200,000.

Asset protection. Under ERISA, pension benefits are “inalienable and non-assignable.” In other words, a business owner cannot be alienated from his pension monies. The Supreme Court ruling of Patterson v Schumate made it certain that a person cannot lose their pension.

In today’s litigious society, frivolous lawsuits are commonplace. Pension monies are one asset that judgment creditors cannot take away.

Vesting. Just because money goes into the plan for an employee does not make it their money. Employer contributions are not a severance plan or a bonus. Employees vest, or earn, their benefits over time. The typical vesting schedule is a “2-20” schedule, meaning if the participating employee leaves the company, he is entitled to none of their benefit if they’ve worked for less than two years. After two years, they are 20 percent vested. Their vesting increases by 20 percent annually until they are 100 percent vested after six years.

One caveat: vesting accelerates to 100 percent upon death, retirement or plan termination.

Tax-deferred growth. All assets in a qualified plan are tax exempt. Under ERISA, pension monies have to be held “in trust” for the participating employees. The trust is tax exempt, so no taxes are due on plan earnings. But, taxes are due on these monies when they are taken out of the plan. In many circumstances, the taxable receipt of funds can be delayed up to age 70.5 when an individual must begin taking required minimum distributions.

With all the above benefits, what is the downside? A DB plan, like a 401k, has annual reporting requirements and requires actuarial certification, creating paperwork for the company. The cost for a DB plan is typically about twice what a 401k plan costs. Unlike a 401k or any other DC plan, DB plans have required contributions rather than allowing a one-time contribution.

But, as always when making a business decision, don’t assume anything and don’t go into a plan blind. Work with a CPA to obtain an illustration of a DB plan custom-designed for your particular situation. Go in with all the facts and review the numbers in black and white.

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