Schweickert & Company — Medmal Insurance

Maximizing Retirement Plan Tax Deductions

Are you taking full advantage of the new retirement plan rules?

By Glen W. Bobo, CLU, ChFC
Director of Education and Training
Pacific Southwest Financial

Many highly compensated business owners have established Qualified Retirement plans. Profit Sharing plans have become especially popular over the past 20 years or so, particularly the type known as 401(k). However, in the rush to jump on the Profit Sharing band wagon, many professionals have overlooked far more effective ways of sheltering large amounts of income from tax.

Here’s a quiz to see if you have fallen for this trap: What is the maximum annual tax deduction available in a tax qualified retirement plan: a. $3,000, b. $13,000, c. $41,000, or d. There is no limit.

If you answered a, b, or c, you correctly identified one of the limits of the various forms of “Defined Contribution” retirement plans. Under these plans, which include such things as Profit Sharing, 401(k), SEP and SIMPLE plans, the IRS limits your contribution to a percentage of your compensation and also an overall annual dollar limit. For example, $41,000 is the 2004 limit for annual additions to a Profit Sharing Plan.

However, since the quiz did not specify any type of plan, the correct answer is actually d. This is because we have another, less familiar family of qualified plans known as “Defined Benefit” retirement plans. Since this approach specifies a benefit, and not a contribution, there literally is no limit on contributions, either as a percentage of current compensation, or as a dollar limit. For example, in a recent case, a 60 year old physician could legally deduct over $176,000 annually! What’s more, he could do this even though he was tapering off his practice and was only actually earning about $100,000 currently, but needed deductions to offset other income he had.

Under these plans, a monthly retirement benefit within the IRS limits is established. An actuary then calculates the annual contribution required to fund this benefit based on life expectancy and interest assumptions. The deductible contribution is whatever it needs to be to fund the benefit.

A particularly powerful variation involves using “Fully Insured Defined Benefit” plans (a.k.a. 412(i) plans) where the guaranteed values of annuities and life insurance contracts are used in place of the actuarial assumptions. Since these are very conservative, even higher contributions are possible. For example a 50 year old could deduct $270,000 annually and a 60 year old $348,000. As you can see, it gets better with age; because the funding period is shorter, more must be contributed to fund the same benefit. However, using a 412(i) could even give a 40 year old the chance to deduct up to $141,000 instead of the mere $41,000 available under Profit Sharing plans. A side benefit is that because of the deductibility of the increased contribution resulting from using insurance, for someone who needs it, the insurance is being effectively purchased at a 95% discount.

Like any tax strategy, these plans are not for everyone. Someone who does not wish to shelter significantly more than $41,000 annually should stick with their Defined Contribution approach, as these plans may offer more flexibility and upside investment potential. Like all qualified plans, only limited discrimination is allowed, so practices or businesses with more than 5-6 non-owner employees can be a problem.

Given the right circumstances, these plans can be a powerful way to shelter income from the tax collector.

Drake Moncur
Schweickert & Company
15 Peters Canyon Road
Irvine, CA 92606
Direct Phone/Fax: 714-689-1784
Email: Drake@schweickert.com