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Defined Benefit Plan Strategy Can Lower Your Client's 2023 Tax Bill
March 22, 2023 •TaxPlanIQ Support team
Tax planning can help business owners reduce their burden in the upcoming tax year. One of the most effective strategies is to establish a Defined Benefit Plan (DBP). This type of retirement plan is designed to provide a predetermined level of income for retirement and can be set up to benefit multiple partners or owners.
As a tax advisor, financial planner, actuary, or third-party advisor, it's important to understand the potential benefits of defined benefit plans for your clients. It’s equally important to use specialists who specialize working in this space.
By advising your client to make annual contributions to the plan, they’ll accumulate more wealth for retirement. Contributions to a DBP are tax deductible, allowing your client to save money — year after year.
Additionally, a DBP can provide greater flexibility for business owners when planning for retirement.
Contributions to the plan are based on the company owner's age and earned income, allowing for maximum control over the amount of money that goes into the plan each year.
Let's take a deep dive into the nitty-gritty of a DBP, look at some case studies to see how it can benefit your clients, and explore some of the risks and opportunities when setting up a plan.
But First, What Is A Defined Benefit Plan?
Defined benefit plans (DBPs) are qualified employer-sponsored retirement plans that can help business owners, solo entrepreneurs, and self-employed individuals save more for retirement while reducing their tax bill.
DBPs are a powerful tax planning tool, especially for high-earning individuals and small business owners. The plan allows the employer to make annual contributions that are tax deductible. This type of retirement plan provides the contributor with a steady stream of income in retirement, and it also allows them to save for the future without worrying about taxes
These plans are especially popular with physicians, attorneys, consultants, married business owners, and other professionals who double as both employers and employees.
The key advantages of a DBP are tax-deferred contributions and the ability to control the amount of money that is invested in the plan each year. With proper planning, your client can reduce their tax liability while growing their retirement savings.
According to the IRS, DBPs provide a benefit based on a fixed formula that is determined at the time of plan establishment. This formula typically uses factors such as the participant's age, salary, or years of service. The benefit formula is used to calculate the amount of income that the participant will receive upon retirement.
To establish a DB plan, your client:
- Can be a business owner of any size.
- Can have other retirement plans.
- Doesn't have to disrupt their 401K
- Can't retroactively decrease benefits
- Can't create this plan in the same year they have SEP and SIMPLE. Meaning if they need a DBP, they have to stop contributions for the year they want a plan for
Many defined benefit plans allow the plan owner to make contributions for employees, including spouses, partners, and dependents. By making these additional contributions, the plan owner can receive a bigger tax deduction and help their family members build a retirement nest egg.
Payment options that are commonly offered include:
- A single-life annuity: This option pays out a fixed monthly amount for the rest of the participant's life.
- Joint and survivor annuity: This option pays out a fixed amount each month for the joint lives of the participant and their spouse.
- A lump-sum payment: This option allows participants to take out a lump-sum payment at retirement.
Many small business owners will take the lump sum and roll their assets into an IRA, similar to a 401(K) plan.
Eligibility For Defined Benefit Plan
In order to qualify for a DBP, the participant must meet certain criteria. These include:
- The participant must have an earned income from that entity. This means that they must be actively employed by the company and not just an owner of the business. They may not be eligible if they sell or retire from a business.
- The businesses should have at least a short history of some steady profits.
- The owner/partners should be at a point where they are comfortable with cash flow to start saving for retirement.
The deadline is the extended due date of the tax return. A solid DB plan workflow takes around a month, so keep the deadline in mind as you prepare to move forward.
Benefits Of A Defined Benefit Plan
When you offer a DBP, your client stands to benefit in several ways.
- Defined benefits plans allow for tax-deferred growth on investments within the plan. Any returns in the plan are not subject to taxation until they are withdrawn. This makes a DBP an ideal option for clients looking for long-term savings, as their wealth accumulation is tax-free.
- Most benefits are insured up to a certain annual maximum by the federal government through the Pension Benefit Guaranty Corporation (PBGC). This provides an additional layer of protection for clients' money, as they can rest assured that their savings are secure.
- Defined benefit plans do not hinge on the performance of underlying investments, meaning that your client's pension value is not affected by market fluctuations. This makes a DBP an ideal option for risk-averse people looking for steady, well-defined returns.
- DBPs can provide a sense of financial security and peace of mind to your clients. They can rest assured that the money they have contributed to the plan will be there when they need it. With DBPs, your clients have the assurance that their retirement income is guaranteed and secure.
- A DBP also provides other advantages to your clients, such as cost savings and flexibility. As an employer, they can save money on administrative costs and customize their plan to meet the individual needs of each owner.
Let's take a look at several case studies to explore how a DBP can help your clients reduce their tax bills.
Case Study 1: Owner-Only Consultant
Profile: Bob is an independent owner only consultant, aged 52, and has a W-2 income of $300,000
Objective: Maximum contribution and tax deduction
Solution: Defined Benefit Plan for 10 Years and a 401(K)
- DB = $202,400
- DB + 401 (K) = $245,000
- Deferred Tax Savings @37%: DB = $74,800 & DB + 401(K) = $90,800
- Projected DB accumulation = $2.78 Million
This is a huge tax savings of $90,800 in 2023 alone. As Bob continues to contribute to his DBP and 401(K), the tax savings will continue to mount up. Bob can also expect the DB account balance to grow significantly over time, providing a steady income stream upon retirement. Remember, a dollar deferred today is worth more tomorrow.
But this is not all! Bob can structure his DBP to leverage various Social Security strategies, such as File & Suspend, allowing him to maximize his benefits upon retirement.
He can also use an investment in an insurance policy to generate tax-free income at retirement, allowing him to maximize his benefits and keep more of what he earns.
Consulting a financial advisor to evaluate the best approach can help Bob make more informed decisions and ensure he is taking advantage of every tax deduction available.
Case Study 2: Married Business Partners With No Employees
Profile: Wife and husband doctors aged 58 and 60, respectively.
Objective: Minimum retirement savings.
Solution: 5 years DB plan with optional 401 (K)
- DB = $422,400
- DB + 401 (K) = $528,600
- Deferred Tax Savings @37%: DB = $163,600 & DB + 401 (K) = $195,500
- Projected DB accumulation = $3.12 Million
This strategy allows the couple to maximize their 2023 tax savings by up to $195,500. The DBP will give them access to a steady stream of income at retirement, as well as other tax benefits. Additionally, the optional 401(K) will allow them to save additional money for retirement.
Case Study 3: Employee with a side business
Profile: 56-Year-old university professor with $150,000 (after taxes) income as a sole proprietor. Income for the last several years was earned from consulting, board fees, and speeches. He wants to retire at 62 years.
Objective: Reduce taxes on side income
Solution: DB plan on side hustle income
- DB = $135,000
- Deferred Tax Savings @37%: DB = $51,000
- Projected DB accumulation = $980,000
Contributing to a DBP on his side hustle income can help this professor lower his 2023 taxes by $51,000. Cumulatively, he can expect his balance to reach nearly one million dollars by the time he reaches retirement age. That ROI alone is enough to convince them to take advantage of this tax savings strategy.
Case Study 4: Retired Corporate Executive, Consulting for a few years
Profile: Aged 70 years, Ann is a retired corporate exec now earning 200,000 in 1099 income. She will need to begin taking distributions from her retirement plan this year and wants to reduce her tax liability while she's working.
Objective: Reduce the tax bill and delay the Required Minimum Distribution (RMDs)
Solution: DB plan for 5 years with a 3-year cliff vesting schedule. No RMDs for this plan until 2023
- DB = 138,600
- Tax saving @37%: DB = 51,200
- Projected DB accumulation = 769,600
Required Minimum Distributions can have a huge impact on the tax liability of retirees. By contributing to a Defined Benefit Plan, Ann can reduce her tax bill by $51,200 year after year while also delaying the RMDs. This will give Ann more financial flexibility and allow her to enjoy larger savings when taking distributions.
Case Study 5: Sole Proprietor opens Db + 401(K) plan to qualify for new 199A deduction
Profile: A 52-year-old doctor is married and nets $500,000 after paying self-employment tax.
New deductions: As an owner of a pass-through entity, he is eligible for a tax deduction (section 199A) of 20% of earned income if less than $326,600 or married.
Objective: Lower taxable income to maximize tax savings.
What Difference does a DB make?
Without a retirement Plan
- Net Profit: 500,000
- Retirement Contribution =0
- Qualified business income: 500,000
- Pass-through deduction: 0
- Taxable income = 500,000
- Tax Bill: 125,900
With a DB +401 (K) plan
- Net Profit: 500,000
- DB +401 (K) plan contribution = 238,100
- Qualified business income: 261,900
- Pass-through deduction: 52,380
- Taxable income = 209,520
- Tax Bill: 38, 440
- Tax Savings = 85,150
This is quite an interesting case. You see, without a defined benefit plan, the doctor would have a taxable income of $500,000 and owe $125,900 in taxes. However, with a DB+401(K) plan, the doctor can reduce his taxable income to $209,520 and save a total of $85,150 in taxes. This is massive tax savings and a great example of how defined benefit plans can help reduce your tax bill in the long run.
Opportunities For a Defined Benefits Plan
- Clients can use alternative assets to add safety and guarantees to the plan if they choose not to take market risk.
- The client has the option of using insurance inside of the plan with an exit strategy to create tax-free distributions.
- Create a very significant tax deduction for the client, helping to maximize retirement savings.
- Opportunity to increase retirement contributions over and above 401k limits
- With 401(K) plan add-on, additional contributions are tax-deductible, and growth is tax-deferred.
Risks For a Defined Benefits Plan
- The financial advisor involved must understand how investments need to be allocated in connection with funding and plan values.
- The owner would need to keep the plan in effect for 3 to 5 years.
- These plans are more complex than traditional DC plans. In order to ensure success, Business Benefits Consultants will quarterback and coordinate with all parties involved.
- While there is flexibility in the amounts payable each year, there needs to be frequent contact throughout the year on any changes in cash flow.
- This strategy is very complex and involves administrative fees.
As you can see, a Defined Benefit Plan can significantly lower a participant's tax bill. But it is important to understand that these plans are often more complex and, thus, more costly to establish and maintain than other types of plans.
It is important to be aware of both the opportunities and risks associated with a Defined Benefit Plan before deciding if it is right for you. Meeting with an experienced Consultant or Tax Strategist who specializes in this niche, can help you understand the potential advantages and drawbacks of this type of plan so that you can make an informed decision.
Grow Your Practice Exponentially By Helping Clients With Defined Benefit Plans
Today, more and more business owners and solo entrepreneurs are looking for legal ways to manage cash flow and reduce their tax liability. And they are willing to pay top dollar for advice and help in doing so.
As a financial advisor, tax planner, CPA, or business consultant, you can leverage the Defined Benefit Plan to provide maximum value for your clients – while also growing your own business. By understanding the advantages and pitfalls of this type of plan, you can develop DBP strategies that will help your clients to take advantage of opportunities while minimizing their risks.
But, really, this is an arduous task and one that requires a great deal of time and expertise. That's why many tax professionals are turning to TaxPlanIQ software to help them navigate the complexities of Defined Benefit Plans and calculate clients' maximum tax savings.
TaxPlanIQ takes the guesswork out of creating a Defined Benefit Plan, saving you from long hours of manual calculations. It does the heavy lifting for you and provides an easy-to-understand interface so you can quickly and easily create, track, and amend plans as needed.
TaxPlanIQ allows you to plug in and set up this DBP strategy on the fly, shows you federal and tax savings opportunities that you're likely to miss, and generates a comprehensive ROI report to show your client the long-term value of a Defined Benefit Plan.
This allows you to set your own fees depending on the ROI you're giving the client. Many tax professionals like you are charging a one-off setup and recurring monthly fees, making them more money while offering clients the best possible service.
TaxPlanIQ also creates a neat presentation and a detailed report detailing eligibility, opportunities, risks, and other resources for the client. By leveraging TaxPlanIQ software, you can confidently help your clients take advantage of their Defined Benefit Plan opportunities and maximize their tax savings.
Sign up today and start leveraging TaxPlanIQ to help your clients optimize their tax savings with a Defined Benefit Plan. It's easy to use, time-saving and provides valuable insights that will help you grow your practice exponentially.