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Kathy is a 50-year old self-employed real estate agent with no employees. Business is good and she expects it to be just as good for the foreseeable future. Her taxable income has been about $250,000 for each of the last three years. Her husband is an executive with a Fortune 500 company.
Their combined income provides them with a nice standard of living, but it puts them in the top income tax bracket. She has hired Sam as her new accountant because he has helped many of her friends reduce their taxes.
In early December of 2006, Kathy calls Sam to discuss her year-end planning. Sam tells her that she will have about $250,000 of taxable income for the year. Sam adds that after factoring in income tax, self-employment tax, and state and local taxes, she will lose about 40% of the $250,000 in taxes. That means that she will pay about $100,000 in tax and will be left with only $150,000 of the original $250,000. Kathy is not happy but she is not surprised.
She has been paying about that much in tax for the last few years. Sam is not so passive. He suggests that they look at setting up a retirement plan for her business and Kathy agrees. Sam calls Joe, an actuary1 who has helped several of Sam’s clients in similar situations.
Joe confirms that a retirement plan would indeed reduce her taxes. If she set up a SEP or profit sharing plan, the company could contribute about $44,000 to the plan. This means that she would save about $17,600 in taxes (.40 X $44,000). So, instead of having $250,000 in taxable income, she would have $206,000. Of course, she would still lose 40% in taxes, but this time that would be only $82,400, leaving her with $123,600. But she would also have the $44,000 in the retirement plan, so she would actually have $167,600 of the original $250,000. This is a pretty good plan, but Joe proposes another idea.
Instead of a SEP or profit sharing plan, Joe recommends that she set up two plans - a defined benefit plan and a 401k plan. Joe explains that the company contribution to the defined benefit plan would be about $125,000 and that she could make pre-tax 401k contributions of $20,000 to the 401k plan. This would reduce Sharon’s taxable income to about $105,000. Again, she would still lose 40% in taxes, but this time that would only be about $42,000, leaving her with about $63,000. But she would also have the $125,000 in the defined benefit plan and $20,000 in the 401k plan, so she would actually have about $208,000 of the original $250,000.
Kathy quickly realizes that this would save her about $58,000 in taxes and allow her to sock away about $145,000 for retirement, but she needs a little clarification.
Joe explains that a defined benefit plan promises an employee a benefit at retirement, based on the employee’s highest three consecutive years of earned income. The company’s required contributions to fund the benefit depend on many factors, the most important being the employee’s income and age.
The maximum benefit that a defined benefit plan can provide is $175,000 per year at age 62. Since Kathy has earned over $250,000 per year for the last three years, her benefit under the plan would be $175,000 even though her average income is $250,000. The annual contribution to provide the $175,000 benefit at age 62 is about $125,000. He explains that her business is an ideal candidate for a defined benefit plan because she has a history of stable income and expects her income to be stable in the foreseeable future.
This is important because the contributions to a defined benefit plan are mandatory. For this reason, he advises her that if she is not willing to commit to funding the plan for at least five years, she probably should not set it up. The contributions to the 401k plan would be discretionary – Kathy could choose not to make them or make a contribution less than $20,000 in any given year.
Of course, Kathy wants to know if the plans could invest in real estate and whether she could self-direct her accounts. Joe explains that Kathy would be the trustee of the plans and that as trustee, she would make the decisions regarding the investments. Since she would be the only participant in the plans, she would, in effect be self-directing her accounts. Both plans could invest in real estate, but he cautioned that she should be careful in the defined benefit plan because the contribution is affected by the investment return – if the assets per form very well, the contribution will be reduced, resulting in a reduction in her tax deduction; if the assets perform poorly, the contribution will increase, possibly beyond her budget. Some have described an actuary as someone who is good with numbers but doesn’t have enough personality to be an accountant. However, there are some of us who are just as much fun as accountants.
This was a lot of information to absorb, but Kathy understood the bottom line – she could save about $58,000 in taxes and sock away about $145,000 for retirement.
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