State of the Union - Part 2: Retirement with a Capital R



Since my last article,  I have received some hate mail. Well, not quite literally unless I count the note from Mrs. Nowotny asking me why I forgot half of the items on the grocery list.  A number of  readers have wondered if I have ever been a member of the Communist Party.  For the record - no but I do like the color red!

The answer to that question really has nothing to do with politics but the lemonade stand that you operated during summer vacation in front of your house as a child. As the cliché goes, "When life serves you lemons, you need to learn how to make lemonade". The plight of the small business owner and employees  in the current economic environment requires some expertise in converting the "economic lemons" into lemonade.

I lamented that the unintentional impact of pension reform over the last quarter century on business owners.  The large scale termination of defined benefit plan in favor of defined contribution plans starting in the decade of the 1980's further descended into small businesses only having 401 (k) plans.  The difficult economic times have resulted in businesses no longer making a matching contribution to employee contributions to the 401(k). The bottom line - employees no longer have pension plans anymore. For that matter, neither do many business owners or at least not the type of plan that they really want, a defined benefit plan.

Business owners have been caught in the trigger hairs of tax reform and entity selection.  Most small businesses operate as S corporations or limited liability companies (LLC).  Business income is taxed to the business owner at individual rates. 

The Current Business Landscape

Most closely held businesses (65-75%) are structured as pass-through entities - S corporations or LLCs.  As a  result, the business owner is taxed on the income at the

The top marginal bracket for taxpayers with more than $400,000 (single and $450,000 married) increased to 39.6 percent. Taxpayers with adjusted gross income in excess of $250,000 will pick up an additional 3.8 percent on unearned income raising the top marginal bracket to 43.4 percent.

These same taxpayers will also be exposed to the phase out of personal exemptions and miscellaneous deductions. These phaseouts effectively raise the marginal bracket by 1-2 percent. Taxpayers in the top marginal bracket will end up with a top federal bracket of 45.4 percent. High income states such as New York and California add an additional 8-10 percent bringing taxpayers to a combined marginal tax bracket of 53-57 percent.

The benefits of qualified retirement plans often lose a lot their luster due to the requirements to provide non-discriminatory participation and benefits for employees. It suddenly makes the plan expensive when the business owner has to contribute for someone else other than himself.

Collectively Bargained Arrangements under IRC Sec 410(b)(3)(A)

IRC Sec 410(b)(3)(A) provides an important exception to the minimum participation rules of qualified retirement plans. This Code section exempts employees that are covered for retirement as well as health benefits under a collectively bargained agreement. the bottom line for the business owner is, the business owner does not have to include the employees in benefit plans if they are covered under a union plan.

The New Math

I am frequently embarrassed after taking a large amount of math and science in college (forced feeding!) to admit that I have the math skills of the average 8th grader. Some people are afraid of heights, and others are afraid of columns of numbers! In spite of that shortcoming, I see the power of being able to exclude employees from participation in the company pension plans. The math works even if you can't count to the number ten.

Many small businesses and professional practices have fact patterns which are very similar to the fact pattern of the strategy example below. A discriminatory defined benefit plan provides the business owner with a guaranteed investment of $5 for every $1 invested into the Plan. The Plan provides a  investment return in excess of 400 percent with guaranteed compounding of 3-5 percent per year. Even with my 8th grade math skills, this is a pretty compelling proposal for the business owner.

Strategy Example

Dr. Ben Casey, age 5o, is a plastic surgeon with his own medical practice. His wife, age 45, works as his office manager. Ben takes an annual salary of $660,000 and his wife takes a salary of $255,000 on revenues of $3 million.

The practice has four employees  with a total annual payroll of $342, 500. The four employees are between the ages of 40 and 60.

The medical group is contemplating a fully insured defined benefit plan under IRC Sec 412(e)(3).  The contributions are significant. The contribution for Dr. Casey assuming funding with life insurance and annuities is $233,000. The funding for Mrs. Casey is $146,000 per year. The contribution for the employee group is $25,000.  Additionally, the medical group could add a 401(k) and profit sharing plans to the mix as well.

Alternatively, Dr. Casey could elect to take advantage of the provisions under IRC Sec 410(b)(3)(A) to exclude his employees from participation in the Plan. The employees are covered under the collective bargaining agreement between the medical group and a union would provide benefits for the employees. The medical group is only required to make a 3 percent match for 401(k) contributions in the union plan - $10,275.

The math analysis for this strategy is compelling. Dr. Casey is a resident of New York City. He and Mrs. Casey are in a combined federal and state tax bracket of  52%. The combined contribution to the fully insured defined benefit plan for Dr. and Mrs. Casey is $379,000. Additionally, both can make maximum 401(k) contributions of $17,500 each plus a catch up contribution of $5,500 for Dr. Casey. The total 401(k) contribution is  $40,500. Additionally, the medical practice makes a profit sharing contribution equal to 6 percent of their earned income for pension purposes - $255,000. Each profit sharing contribution is $15,300 or $30,600 in total.

The total tax deductible  pension contribution is $450, 100 per year for Dr. and Mrs. Casey. The income tax savings are $234,052. The plan costs including union dues and 401(k) contributions into the union pension plan are $47,000 but reduced to $22,560 after taxes.  Each $1 of contribution creates $10.3 of tax advantaged wealth. The return on investment is in excess of 900 percent when all of the tax benefits are included. The return on investment increases in subsequent years as Plan costs decrease.

The combination of plans provides an assortment of benefits - (1) Asset Protection (2) Pre-retirement death benefits of $9.3 million. (3) Guaranteed accumulation at retirement age (65) of $2.542 million each or $5.084 million in total along with a guaranteed retirement income of $410,000.(4) Additional Accumulation of the Tax Savings. Assuming a five percent return within an equity indexed annuity over a 15 year period, the accumulation of the tax savings is an additional $5.3 million. (5) Additional accumulation of the savings on employee contributions ($25,000 - 10,275=14,725) invested in the same equity indexed annuity, the accumulated savings are $333,000.  (6)The 401(k) and profit sharing contributions of $71,000 per year invested over the same 15 year period at 5 percent accumulate to $1.6 million.


A business owner only has three choices - (1) Write a check to himself for savings and investment (2) Write a check to Uncle Sam or (3) Write a check to his favorite charity. There are no other choices!

The ability of a business owner to operate his company pension plan on a discriminatory basis is a dream come true for a business owner. Fortunately, the legal authority is very straight-forward and clear.

The program is well within the legislative intent of Congress as well. The employees are more likely to receive better benefits under the union benefit programs than the typical small business. The business owner can use some of his numerous financial benefits to finance the cost of these benefits.

The investment return when tax benefits and cost savings are considered results in the conclusion that it is unlikely that the business owner can ever duplicate the investment return of his contributions to a discriminatory defined benefit plan. All of this spells Retirement with a Capital R! The current financial and tax uncertainty require the business owner to move quickly to implement this type of strategy.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Gerald Nowotny, Law Office of Gerald R. Nowotny | Attorney Advertising

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