Consistently high-income business owners, including trading businesses with owner/employees close to age 50, should consider a defined-benefit retirement savings plan (DBP) for significantly higher income tax and payroll tax savings vs. a defined-contribution retirement savings plan (DCP) like a Solo 401(k).
DBP calculations are complex
DBP calculations are more complex than a DCP profit-sharing plan. With a DBP, an actuary is required to consider various factors in calculating retirement benefits and annual contributions to the DBP.
The first factor is three-year average annual compensation and the IRS limit is $265,000 (2015/2016 limits). W-2 compensation may be higher, but the actuary may only input the IRS limit. Compensation determines the accumulated retirement benefit and retirement plan distributions/income during retirement years. The IRS limits retirement benefits per year to $210,000 (2015/2016 limits). Based on the maximum factors possible, the accumulated retirement benefit would be approximately $2.6* million.
If the participant plans 10 years of service retiring at age 62, with a 5% growth rate the retirement plan contribution would be $207,000* for the initial years. If that same person has 15 years of participation the annual retirement contribution would be $120,500*. (*Calculations provided by PACE TPA.)
Meet with a DBP administrator/actuary
When you meet with a DBP administrator/actuary, look at some “what if” scenarios with different levels of compensation and years to retirement.
There’s plenty of room for different scenarios between a Solo 401(k) limit of $59,000 for age 50 or older vs. a DBP contribution, which can range between $60,000 and $300,000 per year in the initial years. Traders operating in an S-Corp have the option to use a lower officer compensation amount.
What’s the catch?
A DBP requires annual funding contributions, whereas a DCP does not. With a DBP, the owner/employer commits to saving the actuary-determined accumulated retirement savings amount.
Closing a DBP without a valid reason could lead the IRS to disqualify the plan, making the accumulated benefit taxable income in the year of disqualification. Closing a trading company due to significant trading losses should be a valid reason. On DBP termination, most plan documents allow a tax-free rollover to an IRA or other qualified plan or a lump-sum taxable distribution. The 10% early withdrawal tax rules apply on qualified plan distributions before age 55 (see below).
You should consult your DBP administrator on a timely basis — before June 30 or 1,000 hours of service — to modify the DBP when necessary. For example, if you’re making significantly less income in the first three years, the administrator may be able to lower required contributions. Some DBP administrators recommend maximum allowed funding in early years, which serves to reduce minimum funding requirements in later years. This makes sense as you may make less money as you approach retirement.
You can do direct-access investing or trading inside the DBP account. Leading brokers may allow trading in stocks, bonds, ETFs and restricted trading in options. Avoid margin interest, which triggers unrelated business income tax (UBIT). Caution: Investment losses in the DBP will require larger contributions to make up those losses. Conversely, stellar trading gains can serve to reduce contributions too.
In an S-Corp, only wages are considered in compensation; pass-through Schedule K-1 income is not. Conversely, with an operating business partnership tax return, all self-employment income (SEI) including guaranteed payments and pass-through income for active partners is included in compensation. A trading partnership has underlying unearned income, which is not SEI.
Payroll tax savings
Under DBP rules, average compensation is determined over the initial three years of the plan and compensation amounts afterward don’t affect DBP contributions and benefits. After three years, a trader may significantly reduce officer compensation, which has the effect of reducing payroll taxes. Payroll taxes include FICA 12.4% up to the SSA wage base amount of $118,500 (2015 and 2016 limits) and unlimited 2.9% Medicare tax. Plus, upper income taxpayers have a 0.9% Medicare/Obamacare surtax on wages. That leaves traders enjoying the tremendous income tax savings with a much smaller offset of payroll taxes. This option to reduce payroll taxes is not available with a Solo 401(k).
An S-Corp trading company has underlying unearned income, which should be an acceptable reason to the IRS for why the S-Corp may not otherwise comply with IRS guidelines for reasonable officer compensation. Conversely, a regular S-Corp operating business like an investment manager receiving management fees or an IT consultant must adhere to IRS guidelines for reasonable compensation. Currently, the guidelines call for 25% to 50% of net income before wages to be officer compensation.
Establish a DBP and execute payroll before year-end
Speak to a DBP administrator well before year-end to establish the plan by Dec. 31. You can fund the plan up until Sept. 15 of the following year — the extended due date of the S-Corp tax return.
You also need to execute officer compensation payroll before year-end.
Although the DBP is based on a three-year average of compensation, you may open a DBP in the first year of S-Corp trading company. Without a three-year average in that first year, there’s a narrower range of minimum vs. maximum contributions each year. If your income drops considerably in the second year, contact the DBP administrator, who can probably modify the plan to lower compensation amounts. After the three-year average of compensation is set, the administrator can’t modify it lower. You also can’t unwind accumulated retirement benefits earned to date.
Types of DBP plans
For an S-Corp trading company with a single owner/employee or a spousal S-Corp with two employees and no outside employees, we recommend a traditional or personal DBP or a “cash balance” DBP with a separate DBP investment account established for each owner employee.
Two spouses working in an S-Corp trading company can take advantage of the hybrid plan: A DBP integrated with partial Solo 401(k) (elective deferral and 6% profit-sharing rather than the normal 25% profit-sharing). If there’s only one employee, the traditional DBP or cash balance DBP is used.
There are many anti-discrimination rules and requirements for high-deductible qualified plans intended to prevent the owner/employee from enjoying huge benefits with “top-heavy plans” while omitting or short-changing non-owner employees. Plan designers offer options like vesting over several years for complying with these rules but still favoring owners where possible.
Affiliated service group (ASG) rules apply in a similar context. If you own a business with many employees, you can’t exclude those employees by owning a separate (affiliated) S-Corp trading company with a high-deductible qualified plan for you alone. Consult an employee-benefit plan attorney.
Consult your tax advisor
After you speak with a DBP administrator, actuary, and perhaps an employee-benefit plan attorney, consult your tax advisor on choosing the compensation amount, which drives the related targeted retirement savings goal under the DBP. For S-Corp operating businesses, officer compensation must adhere to IRS guidelines for reasonable compensation, too.
Make sure you are comfortable committing to the annual minimum funding amounts of the DBP. If you want a lower commitment, choose a lower compensation amount. If the DBP calculation shows an annual contribution under $60,000, you are probably better off choosing a Solo 401(k) as it does not require annual funding and its limit is $53,000 for under age 50 and $59,000 for age 50 and older (2015 and 2016 limits).
With Solo 401(k) retirement plans, our CPA firm doesn’t want to see a S-Corp loss after deducting compensation and the retirement plan contribution. We apply this same rationale to the first year of a DBP plan. It’s wise to have sufficient S-Corp year-to-date trading income and expect similar trading gains in subsequent years so there won’t be an S-Corp loss from these large deductions. Once you start the DBP, mandatory contributions may generate a net loss in the S-Corp and that is acceptable. Explain the net loss and DBP funding commitment in a tax return footnote.
Your S-Corp trading company must qualify for trader tax status (business expense treatment), otherwise you can’t have officer compensation and retirement plan contributions in an investment company.
Costs and tax filings
DBP administrators charge $1,200 to $2,000 to design and establish a DBP. DBP administrators also charge around $1,200 to $2,000 per year for plan administration to keep the plan up to date along with modifications based on your evolving needs and changes in the law. Employee-benefit attorneys charge closer to $3,000 to $5,000 or more for DBP design and an attorney is not required. Net tax savings far exceeds these reasonable fees. In many cases, the DB administrator covers the cost of an independent actuary.
Charles Schwab offers a Personal Defined Benefit Plan and they have good resources on their site.
The IRS and The Employee Retirement Income Security Act of 1974 (ERISA) have many stringent rules and requirements for DBPs and it’s imperative to stay in proper compliance. Keep your DBP administrator aware of changes so they can make necessary modifications to the plan on time. There are many pitfalls to avoid with DBP and it’s not as simple as a Solo 401(k) or IRA.
As with all qualified plans, the sponsor of a DBP most likely must file an annual IRS Form 5500 tax return due July 31 of the following year for calendar year entities and plans. A 2½-month extension to Oct. 15 is allowed on Form 5558. Several administrators help with this tax form.
Tax-free growth and retirement distributions
Unless you are making non-tax-deductible contributions to a Roth IRA or Roth Solo 401(k) plan, with traditional retirement plans including qualified plans and IRAs, you get an income tax deduction from gross income for the contribution amount.
With a Roth plan, tax savings are permanent. Conversely, with a traditional qualified plan like a DBP or DCP, there is only tax deferral. Enjoy tax-free growth in the plan until taking taxable retirement plan distributions in retirement years. For traders who do more short-term investing, this annual tax savings is huge. Use a retirement plan calculator and you’ll see the power of tax-free compounded growth. Consider the time-value of money with tax deferral as well.
Under current tax law, retirement-plan distributions are ordinary taxable income. “Early withdrawals”(before retirement years age 59½ in an IRA or age 55 in qualified plans) are also subject to a 10% excise tax penalty on IRS Form 5329. Qualified plans including Solo 401(k) and DBP can offer qualified plan loans, which avoid early withdrawals. Qualified plans are a form of deferred compensation, but there are no payroll taxes on retirement plan distributions or contributions.
In qualified plans, there are required minimum distributions (RMD) by a participant’s required beginning date (RBD). The RBD rule is similar to the RMD rule for IRAs with distributions required no later than by age 70½.
If you are close to age 50, have consistently high annual income, can afford to commit to large tax-deductible contributions and want to smooth your taxable income in retirement taxed at lower tax brackets, then a DBP may be for you. The tax savings is enormous and with tax-free compounded growth it’s an incredible retirement savings tool.