Now, you’ve probably heard about 401(k) plans, right? Most business owners have them because, well, that’s just what businesses do.
But what if I told you that the 401(k) is just the tip of the iceberg when it comes to maximizing your retirement contributions and reducing your tax liabilities? Stick around, because today we’re unlocking the secrets of Profit-Sharing Plans and Defined Benefit Plans, showing you how to structure them to benefit not just your employees, but you, the business owner, and your key personnel. Trust me, you won’t want to miss this!
Profit-Sharing Plans: More Than an Employee Perk
Profit-Sharing Plans allow business owners to make discretionary contributions to their employees’ retirement accounts based on the company’s profitability. While the idea of “sharing profits” may initially sound like it benefits only the employees, a well-designed Profit-Sharing Plan can favor business owners and key personnel.
Example:
Suppose your business turns a profit of $1 million. With a Profit-Sharing Plan, you could contribute up to 100% of an employee’s compensation or a maximum of $66,000. If you earn a salary of $300,000, you could potentially contribute $66,000 to your retirement account depending on your age.
However, these plans can be structured in such a way that the majority of the contribution can go to the business owner and key personnel. By utilizing a tiered or new comparability formula, you can allocate a higher percentage of profits to select groups within the company, making it a win-win for business owners and their most valuable team members.
Tax Benefit:
Assuming a 37% tax rate, a $66,0000 contribution could result in tax savings of approximately $24,420.
Depending on your employee pool and situation, you may end up contributing less than that $24,420 to other employees. Would you rather write that check to Uncle Sam or to your employees?
Defined Benefit Plans: The Old is New Again
Defined Benefit Plans promise a specific monthly benefit at retirement and can offer higher contribution limits than Profit-Sharing or 401(k) plans. Types of Defined Benefit Plans include Traditional Defined Benefit Plans, Cash Balance, Target Benefit, and Money Purchase Plans. While these plans are powerful retirement savings vehicles, they each come with their own set of rules, advantages, and ideal use-cases. Understanding these can help you make the best choice for your financial strategy. We will address the Traditional Defined Benefit Plan and Cash Balance Plan today.
Traditional Defined Benefit Plan
What It Is:
A Traditional Defined Benefit Plan is a retirement plan that promises a specific benefit amount at retirement. The benefit is typically based on a formula that takes into account factors like age, years of service, and salary.
Advantages:
- High contribution limits, which are particularly beneficial for older business owners who are closer to retirement.
- Contributions are generally tax-deductible, reducing current tax liability.
- Provides a predictable retirement income.
When to Use:
This is ideal for business owners who are closer to retirement age, say over 50, and are looking to supercharge their retirement savings. It’s especially beneficial for those with a stable, high income who can commit to funding the plan consistently.
Example:
If you are nearing retirement (over age 50) and have a high consistent income, a Defined Benefit Plan could allow you to contribute up to $265,000 per year, depending on your age, salary, and years of service.
Tax Benefit:
With a 37% tax rate, a $200,000 contribution could translate to tax savings of $74,000 for the year.
Cash Balance Plans
What It Is:
A Cash Balance Plan is a type of defined benefit plan that maintains hypothetical individual employee accounts, much like a defined contribution plan. However, the investments are managed collectively by the plan’s trustee, not by the individual participant.
Advantages:
- Allows for higher contribution limits compared to a 401(k) or Profit-Sharing Plan.
- Tax-deductible contributions.
- Lower volatility in investment returns compared to 401(k)s as the assets are professionally managed.
When to Use:
This plan is best for business owners who have a consistently high income and are looking to both lower their current tax liabilities and aggressively save for retirement. Cash Balance Plans offer flexibility, making it useful for those whose income might vary from year to year.
Example:
At age 55 and an annual salary of $300,000, depending on actuarial calculations, you could contribute between $150,000 to $200,000 per year to a Cash Balance Plan.
Tax Benefit:
At a 37% tax rate, this could mean tax savings of up to $74,000 annually.
Both Defined Benefit Plans offer the ability to make large, tax-deferred contributions, but they serve slightly different needs and risk tolerances. Traditional Defined Benefit Plans are great for older business owners looking for a predictable retirement income, while Cash Balance Plans offer more flexibility and are more forgiving if you have fluctuating income.
By understanding the nuances of each plan type, you can make a more informed decision about which retirement saving strategy best aligns with your personal financial goals and the goals of your business.
The Power of Combination Strategies
You don’t have to pick just one of these options. Business owners can combine different retirement plans for maximum benefit.
Revised Example:
A 50-year-old business owner with an annual salary of $400,000 might:
Contribute $30,000 to a 401(k)
Contribute $36,000 to a Profit-Sharing Plan (keeping it under the IRS limit of $66,500 including catch up contributions)
Add another $150,000 to a Cash Balance Plan
That’s a total contribution of $216,000 in a single year.
Tax Benefit:
With a 37% tax rate, the tax savings could amount to approximately $79,920.
401(k) plans are an excellent start, but they shouldn’t be the end-all-be-all of your retirement and tax strategy. By including Profit-Sharing Plans and Defined Benefit Plans in your financial planning, you can better align your money with your business goals, and effectively manage the complexities that come with business ownership. With the right combination and structure, these advanced plans can serve as potent tools to minimize taxes and maximize retirement contributions, benefiting both the business owners and key personnel.
As always, talk to your financial advisor, Did I mention I am one of those, or your tax professional about whether this may be the right fit for you and your business.
Alright, folks, that wraps up today’s deep dive into the various types of retirement plans that go beyond the 401(k). As you can see, there’s a whole world beyond the typical 401(k) that could help you significantly reduce your tax liabilities while supercharging your retirement contributions. If you find this video valuable, don’t forget to hit that ‘Like’ button and subscribe to our channel, so you don’t miss out on future episodes of “Bridge to Wealth.”
You can also check out my website Buildingtowardswealth.com and in the top right corner you can book a call with me to discuss your situation. Your financial journey is important to us, and we’re here to guide you every step of the way. Until next time, Keep Building!
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