Q. My husband began a business over 15 years ago. The first few years were pretty lean, but we committed to trying it for 5 years and are glad we stuck with it; in year four, it started to really take off. He has a solo 401(k), and I work for a company that has a 403(b) plan. We both contribute the maximum, which includes the catch-up (we are both over 50). His plan also has some sort of profit sharing component. We both plan to work until at least age 62, which is around 8 years from now. We have a pretty decent size nonretirement portfolio; it’s actually larger than our combined retirement accounts. My husband is now talking about putting even more away for retirement by setting up something called a defined benefit plan (DBP). He says he could put more than $50,000 in the plan for this year and future years in addition to his 401(k)/profit sharing plan. The person suggesting this says it must be a five-year funding commitment. My husband doesn’t see this as a problem because if his income declines, we would just sell some nonretirement assets and use those to fund the DBP. We’d actually need to sell some mutual funds to fully fund it for this year, since he recently took a draw for $50,000 and we’ve already invested the money. I don’t understand how it makes any sense to take money we’ve already paid taxes on and invested, sell these and then take the cash and put into the DBP. Now we are taking after-tax money, putting it in a retirement account and then paying taxes on it again when we take distributions in retirement. We are in a high tax bracket now and will probably be in the same or a lower bracket in retirement. My husband says it all makes perfect sense when the guy explains it to him but that he can see my point. Does it make any sense to you to fund the DBP with after-tax money?
A. First of all, congratulations to both of you for having a successful business. Secondly, don’t establish any plan and invest money until you understand the pros and cons of the plan and decide if it will be of benefit to you. Without more personal information, I can’t suggest whether a DBP would be appropriate for your husband’s business, but I may be able to help you with the decision process.
The main attributes of an ideal candidate for a DBP is an older (age 50+) business owner with no employees or with much younger or lower-paid employees, a proven track record of profits and the confidence that the business will be able to fund the plan at minimum levels for at least 5 years. A DBP lets an employer deduct the cost of funding a fixed pension for the employee(s) based on their current age, salary and a predetermined retirement age. The closer the employee is to retirement and the higher the earnings, the more the business can put away for that employee’s retirement pension. The employee may continue to work beyond the predetermined retirement age and, if the plan allows, may elect to take a lump sum versus the pension payment. The lump sum is eligible to be rolled directly into an IRA.
Your concern that your husband would take after-tax money to help fund the plan is understandable. What you are forgetting to take into account is the value of the current tax deduction for the contribution. Example: Assume you are in the 35 percent tax bracket and have some after-tax investments that have little or no gains. If there is not enough cash in your husband’s company to fund the DBP, sell enough of your after-tax investments to generate $50,000 in cash. The $50,000 goes back into your husband’s company, which eliminates the taxable draw he took earlier. The $50,000 now goes into the DBP and is tax-deductible to the business. Instead of paying 35 percent federal tax on the $50,000 this year, your husband’s business gets a tax deduction for the contribution. You’ve eliminated $17,500 in federal income tax for 2015. Yes, you will have to pay taxes on the $50,000 when you withdraw the money, but you’ve deferred this expense for at least eight years.
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Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 97128, Raleigh, NC 27624