Before we dived into pension plans, though, let’s first understand what retirement plans are. There are two kinds of retirement plans – qualified and non-qualified. Qualified retirement plans are IRS approved, and you can take income tax deductions off of your contributions to your plan. Profit sharing plan, SEP plan, defined benefit plan, solo defined benefit plan, 412(e)(3) defined benefit plan (also known as 412(i) plan), cash balance plan are all count as qualified. Non-qualified retirement plans would include a deferred compensation plan, your taxable brokerage or savings accounts. You would not be able to take income tax deductions of your contributions to these kinds of accounts or plans.
In terms of qualified retirement planning options, there are two primary plans – defined contribution plans, and defined benefit plans. Defined contribution plans include profit sharing, SEP and 401k retirement plans.
Understanding Defined Contribution Plans
As the name suggests, in this plan, you define the contribution you make. For example, you would contribute lesser of $58,000 or 25% of participant’s compensation to your defined contribution plan in the year 2021 plus $6,500 in catch-up contribution if you are of age 50 or above ($61,000 for year 2022 plus $6,500 catch-up contribution). For example, a business owner makes $200,000 in W2 income from his or her business. That business owner could contribute lower of $58,000, or 25% of compensation ($200,000). Since that amount would total $50,000, he or she would contribute the lower amount of $50,000 to their defined contribution plan like Profit Sharing Plan or SEP.
Understanding Defined Benefit Plans
In a defined benefit plan, a person does not define the contribution made to the plan, but rather, the amount of the retirement benefit at the retirement age. Qualified Pension Actuary or Attorney will base your current age and income to calculate your allowable retirement benefit ($230,000 maximum for the year 2021 and $245,000 for year 2022) at your retirement for example at your age 62. Then, the next step is to calculate annual defined benefit plan contribution amount to ensure adequate benefits at retirement. Let’s use the example mentioned earlier. You may receive retirement benefit lesser of $230,000 or 100% of average compensation for the highest three consecutive years according to IRS 2021 numbers from their defined benefit plan. To achieve that benefit at retirement how much should the above-mentioned business owner contribute to the defined benefit pension plan (at given rate of return on the contribution investment) now?
These calculations can easily become very complex, and that is why they are calculated by qualified pension actuaries. Essentially the biggest bonus to a defined benefit plan is that it will give you a significantly larger deduction, up to $350,000, as compared to the maximum of $58,000 limit for the year 2021 deduction from a defined contribution plan.
There is still time to set up Defined Benefit Plan for year 2021 in the year 2022 up until your tax return filling deadline including any extensions.
There are two different kinds of defined benefit pension plans. The first is called a traditional defined benefit plan, and the other is called a fully insured defined benefit plan. The latter is also known as a 412(e)(3) plan. With the fully insured 412(e)(3) defined benefit plan, an actuary can take a lower assumed guaranteed interest rate on your contribution to plan, resulting in higher income tax deductions for you.
Pension plans are a great income tax and retirement planning tool, but they require special expertise to get the maximum benefits possible, as there are many IRS rules to be followed in regards setting up the proper plan documents (including and excluding the employees, contribution limit to the plan, validating a plan and filing the annual 5500 pension tax return to IRS).
At BeamaLife, we manage many defined benefit pension plans and have the best plan designs in the country. To get the biggest deduction possible, whether you are a successful business owner, doctor, independent pharmacist or any other self-employed professional, please call (732) 508-7415 to speak with pension plan expert or complete personalized proposal form now.
