The day has finally arrived: You are making more money in your practice than you have ever made.
Trust and estate attorney Bob Johnson realized he had finally arrived. His practice was thriving after years spent investing in it. His household expenses were simultaneously declining, as his children made their way through private school and college.
It was time to catch up on his retirement savings.
“All along I’ve said, ‘Once these kids are out of school, I’m going to take all the money I’ve been paying for school and pack it into our retirement plan. I’m going to spend the next 10 years of my life building up my retirement.’”
It was a great plan.
The sticking point? Taxes. The more he made, the more he’d be taxed on his hard-earned money. As a small business owner, he knew the contribution limits of his Simple IRA. Even with the catch-up contribution (Bob is over 50), his yearly contribution limit for SIMPLE IRA plans in 2022 increased only $3,500.
That’s not much of a catch-up plan. Bob needs to save larger chunks of money for retirement. That’s when Bob was introduced to the Defined Benefit Plan.
The Defined Benefit Plan
The Defined Benefit Plan is an IRS pre-approved retirement plan for high-income earners. In 2022, participants could sock away up to $245,000, pre-tax.
That’s a lot of savings.
The IRS has a few rules about who can participate in a Defined Benefit Plan, but many attorneys who own practices may qualify.
Here is everything you need to know about investing in a Defined Benefit Plan.
How It Works
For starters, you must qualify for this specialized IRS-approved retirement program. It’s not for everyone. In short, the Defined Benefit Plan was designed for small business owners, consultants, and independent contractors.
We’ve developed a simple quiz to see if you may qualify: The Defined Benefit Quiz.
Second, you want to be in a position where you can put away a large percentage of your income for several years. You’ll want to talk to a financial advisor with expertise in Defined Benefit Plans, in order to identify the percentage of your current income you can comfortably afford to contribute to the plan, up to the maximum allowable amount. Currently, regulations set the maximum annual benefit at $245,000. Of course, you can put away less than that.
The good news is that you can customize your annual contribution, given the risk of how revenue can fluctuate in a small business. There are minimums that are required by the plan. Defined Benefit Plans are actually flexible. In fact, you have until you file your taxes to fund the plan for the previous year to modify your minimum and maximum. The latest deadline is September 15 of the following year.
How Your Contribution Is Calculated
Here’s how it works. Your annual contribution is calculated using formulas designed by actuaries, based on:
- Current age — the older the business owner, the larger the annual contribution needed to reach any specific benefit target because the owner will have fewer years to contribute.
- Compensation — Eligible compensation differs based on the type of business.
- Planned retirement age — a date you set for yourself for the plan. Not when you actually retire. Typically, at least three years from the year the plan is adopted.
Of course, the shorter the horizon to retirement, the higher the annual contribution can be without exceeding the $245,000 limit. Conversely, a longer horizon results in a lower annual contribution limit.
A financial advisor with expertise in Defined Benefit Plans can help design a plan that can be modified when your situation changes. The general rule of thumb, however, is to only do this type of plan if you plan to fund it for three years or more.
Because of changes in regulations through the Pension Protection Act of 2006, there are many tools and strategies that can be built into your plan for flexibility. Assets may be invested in mutual funds, bonds, equities or other marketable securities. Investments with low volatility are generally recommended.
The Payoff
It doesn’t take long to start seeing the payoff of a Defined Benefit Plan. You’ll see real results when you file taxes the first year you contribute! It’s typical for clients that use this type of plan to receive tens of thousands of dollars back on their tax returns each year.
When done over multiple years, this approach can save you hundreds of thousands of dollars total. And that means more dollars toward your retirement.
In the end, when you invest in a Defined Benefit Plan, the total benefit single sum could be as high as $3.2 million (2022), which can be paid as early as age 62 or later. (The $3.2 million benefit amount adjusts higher each year with an inflation calculation.)
Your retirement might be closer than you think.
