The 1939 movie Mr. Smith Goes to Washington tells the story of a proverbial "do gooder" (played by James Stewart) who goes to Washington as the junior senator from his state, hoping to make important changes but finds himself surrounded by dirty politics. It was made in 1939 but all of the backroom dealing and dirty politics are alive and well 70 years later. Nothing ever seems to change in Washington . I am convinced that Republicans and Democrats would be unable to agree on the location for the Annual Congressional Christmas (correct - Holiday) Party.
One of the benefits for having served the "People" is a very generous retirement and employee benefits package. Even more interesting is viewing these benefits in relation to your own. The question to be answered is "Can you have a retirement plan equal to or better than a Congressman or Senator without serving in Congress and ruining your reputation.
This article will focus on how a business owner without the benefit of political clout and cronyism can create a pension plan that is better than the Congressional Pension Plan and the defined benefit programs that for federal, state and municipal workers.
The Days of Wine and Roses (and Defined Benefit Plans)
According to the Joint Committee of Taxation, 94 percent of businesses operate as S corporations or some form of pass-through entity - partnership or LLC. In the current landscape, business owners are feeling the impact of higher taxes. 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, New Jersey and California can add an additional 8-10 percent bringing taxpayers to a combined marginal tax bracket of 53-57 percent.
In 2010 (not that long ago!) the Treasury Inspector General for Tax Administration performed a study on the statistical trends in retirement plans. The results of the study showed that pension plan participation had increased dramatically over the last thirty years (1977-2007) but that the risk of funding retirement has shifted from employers to employees.
In 1977, two-thirds of employees were covered by defined benefit pension plans. Over the thirty year period, defined benefit participation dropped to 23 percent. According to the U.S. Bureau of Statistics, fewer than 20 percent of U.S. workers are covered by defined benefit retirement plans. These statistics include the 8.8 million federal employees and 19 million employees covered by state and municipal plans. The bottom line is this - if you work in private industry, the chances of being a participant in a defined benefit plan are "slim or none!"
In my view the dramatic drop in defined benefit participation by private employers is far worse when you consider that a healthy percentage of the defined benefit plans are made up of state and municipal plans. As result, employees are expected to shoulder more of the funding of their retirement as taxes have gotten higher.
It is my strong contention that every business owner would desire a defined benefit plan as the foundation of his retirement planning if he did not have suffer the cost of funding for his employees.
The Congressional Pension Plan is a good example of the perks of being covered under a good defined benefit plan. The defined benefit plan provides a benefit for Congressmen who began participation before 1983 at a rate of 2.5 percent of the three year highest average salary for each year of service. Ten years of service provides a retirement benefit equal to 25 percent of the Congressman's highest salary. Based on the current salary of $174,00 the retirement benefit is $43,500 per year.
For Congressman entering the plan after 1983, the credit is 1.5 percent for each year of service. Congressman now contribute to social security and receive benefits for social security retirement benefits which was not previously the case. A Congressman with thirty years of service would receive a pension at age 62 of $130,500 per year.
The Congressional 401(k) Plan provides a 5.0 percent match of salary plus an additional 1.0 percent of salary regardless of whether or not the Congressman contributes to the Plan. The U.S. government pays 70-75 percent of the cost of post-retirement health insurance coverage. Nice work is you can get it!
Collectively Bargained Arrangements under IRC Sec 410(b)(3)(A)
The pension rules have strict rules regarding minimum participation and non-discrimination and minimum benefits. I belabored the point in Part I and Part II of this series that there is an important exemption to this rule - employees covered under a collective bargaining agreement with a union may be excluded from participation.
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.
While the thought of union employees may be revolting to many business owners, the choices for the business owner can be narrowed to three choices - (1) Pay yourself; (2) Pay the Government 0r (3) Give your money to Charity. Presumably, a collective bargaining agreement with a business-friendly union (they do exist!) can strike a balance between a business owner and his employees. Better to have a job than not to have a job!
How deep is your love (for Uncle Sam)?
A Horse of a Different Color
Previously I have focused on the fully insured defined benefit plan under IRC Sec 412(e)(3) as a solution for the business owner to create the largest tax deductible deduction with guaranteed retirement benefits. With a fully insured defined benefit plan, you won't end up like the participants of the City of Detroit pension plans with huge underfunding in the pension plan. The benefit payments are guaranteed by investment grade life insurers.
Nevertheless, some business owners and their advisors may believe that an insurance funded defined benefit plan is too conservative and unappealing for their sophisticated investment tastes. The traditional or split funded defined benefit plan is a fine solution.
In many respect following the Pension Protection Act of 2006 while introducing a number of provisions for under-funded pension plans, added more flexibility in terms of funding than previously existed for defined benefit plans. It can now be a great contribution if your business has great and average years of financial performance.
In the present case, the planning objective is to maximize the level of contributions and benefits for the business owner. The planning design provides for the inclusion of features and ancillary benefits to maximize contributions. Some of these provisions include (1) Form of Benefit - Joint and Survivor 100 percent, i.e. no reduction in benefit payments over the life of the survivor. (2) Incidental death benefit - The plan provides an incidental death benefit during retirement rather than ending at retirement. (3) Disability Benefit - provides for benefits in the event of disability(4) Post Retirement Uninsured Medical and Long Term Care Benefits. The contribution component is limited to 25 percent of payroll. In small businesses, this may be a relatively small number. This component can be added after the defined benefit plan is fully funded.
Unlike a typical defined benefit plan which provides the option of a lump sum payout at retirement based upon a single life only annuity payout, this plan version is "benefit oriented" instead of being lump sum driven. The upside side of the tradeoff is a much larger tax deductible contribution.
John Smith, age 52, operates a small manufacturing company that provides specialty goods to the Department of Defense and other government agencies. His personal income is $1 million per year. He has twenty employees and an annual payroll of $1.5 million.
The employee average age is 45. John's current pension administrator has presented a new defined benefit option for consideration. John feels that the costs and benefits for both the company and himself are not attractive.
John's attorney (you or me) suggests that he consider establishing a defined benefit plan but suggests excluding the employees as result of the unionization of his employees. John elects 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 company with a business friendly union that would provide benefits for the employees.
John adds his wife Betty, age 50, as an employee and participant in the plan and pays her the maximum allowable salary for contribution purposes in 2013 - $255,000. The defined benefit plan is a split funded plan, i.e. funded with investments and life insurance. The plan provides for retirement at age 65 with an annual retirement benefit of $205,000 for John and $205,000 for Betty -a total of $410,000 per year.
The Plan also provides a pre and post retirement death benefit equal to 100 times the monthly plan benefit. The Plan includes a cost of living increase on retirement benefits of three percent. Each participant's benefit provides for a 100 joint and survivor annuity payout. The plan also provide for benefit payments in the event of each participant's disability. Contributions for post-retirement medical benefits will be added once the Plan is fully funded for retirement purposes. The plan does not have a lump sum option.
The defined benefit contribution for John in 2013 is $484,000. The defined benefit contribution for Betty is $430,000. John and Betty will each be able to make a full 401(k) of $17,500. Each participant is able to make a catch up contribution of $5,500. The company is able to make a contribution into a profit sharing plan of $51, 000 in 2013 for each participant.
The total deductible contribution for the company is $1,051,000. The only participants are the business owner and his spouse. The tax savings for John is a combined tax bracket of 50 percent are $525,500. The company's match to the union 401(k) plan is the same as it was before. Additionally, he is paying slightly more for his employee's healthcare than he was before. The difference is that the quality of coverage is dramatically better. Additionally, the union's history for rate increases has been very stable and low relative to the commercial marketplace. Everybody is happy!
What if My Name is Not Daddy Warbucks?
So far I have demonstrated the benefits of the proposed solution for the highly compensated and "rich and famous". But what about the business owner that is prosperous but not wealthy? What happens if he has a great year this year and a horrible year in 2014. God forbid!
Bob Jones, age 55, is a solo practioner with three employees. Bob has a general practice including some personal injury work. In a good year, Bob settles a nice "slip and fall" case and receives additional compensation through the contingency fees. In other years, John's income is stable, averaging $150,000 in personal compensation for himself. In a good year, his income can double to $300,000 or more. In a bad year, his income can be $120,000-130,000.
John has had a late start in his retirement planning and would like to make up for lost time. He decides to have his employees covered under union plan. He forms a split funded defined benefit plan along with a 401(k) and profit sharing plan which allow for flexible contributions. The defined benefit plan provides for retirement at age 65 and will provide him with a projected retirement benefit of $150,000 per year. The plan is loaded with ancillary benefits - (1) 100 percent joint and survivor retirement benefit (2) Pre and post retirement death benefits (3) Disability benefits (4) Post retirement medical and long term care benefits.
In 2013, John settles a personal injury receives contingency fee income of $350,000 so that his total income is $500,000. John is able to make a tax deductible contribution of $365,000. He makes a 401(k) contribution of $23,000 as well. His profit sharing contribution is $15,300. The total contribution is $398,300.
In 2014, John has a mediocre year and does not settle any personal injury cases. His total compensation is $150,000. His contribution to the defined benefit plan is $25,000. He does not make a contribution to his 401(k) or profit sharing plans.
You don't need to be a member of Congress in order to receive political favor under the law at least when it comes to retirement planning. The ability to exclude employees from benefit plans allows the business owner to maximize contributions and benefits for himself and his spouse. The statutory tax benefits of qualified retirement plans remain as the most powerful and "black and white" with respect to legal authority and challenge.
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.
This article demonstrates that it does not matter what type of defined benefit plan that you establish- fully insured, or split funded. When you exclude employees from participation, the path is and only be clear. The level of contributions are flexible to accommodate fluctuations in earnings.
In high income years, the business owner can make larger contributions. In average years, the business owner can stable contributions and in bad years, the business owner can make a minimum contribution that can be as low as 20 percent of the regular contribution.
The layering of the defined contribution plan - 401(k) and profit sharing allows the business owner to take larger investment risks with those assets and have more upside to complement the defined benefit fixed monthly income at retirement. The combination of the two concepts makes for a very powerful combination of large tax savings, tax referral and more importantly, a comfortable retirement.