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Tax saving opportunity with 2004 pensions

by Tony Novak, CPA, MBA, MT
, revised 11/29/2011

The newly-released retirement plan limits for 2004 reveal a tax-planning opportunity for older high income individuals. Most of the changes will have minimal impact. The maximum tax-deductible contribution in defined contribution plans increases only slightly from $40,000 to $41,000. - this includes the most popular types of plans like 40(k), profit-sharing and money purchase pension plans. The maximum allowable contribution to a 401(k) increases from $12,000 to $13,000 and the "catch-up" allowance increases from $2,000 to $3,000. These $1,000 changes are not likely to inspire any financial planning shake-up.

The more interesting change is the maximum allowed benefit for defined contribution plans. This allowance is increased to $165,000 from the 2002-2003 level of $160,000. While a $5,000 increase might not appear to be a big deal at first glance, it is important to understand how this benefit is derived.

First, the increased benefits allowance is only significant to individuals with a taxable earned income of more than $160,000. Lower income employees are not affected by the higher limit. This is clearly a tax break targeted for higher-income people.

Second, the $5,000 increased benefit brings the possibility of much larger annual tax-deductible contributions. In order to increase the pension benefit by $5,000 per year, the pension plan must accumulate (roughly) $100,000 in additional assets by the time the participant retires. (The $100,000 figure is just a general assumption for the sake of this discussion. The actual amount will depend on the actuarial assumptions in the pension plan). An older participant with only a few years from early retirement date, the annual contribution toward that $100,000 could be substantial. For example, a self-employed 55 year old planning to retire at age 60 would be allowed to deposit approximately $20,000 more in tax-deductible contributions for 2004 than was allowed in 2003. The total tax-deductible contribution can be up to 100% of earned income up to $205,000 in 2004.

Third, while pension plans are more common in larger corporations, this additional allowance can also be used by pension look-alike plans that are more popular with small businesses. This includes target benefit plans and 412(i) annuity plans. This type of pension plan is particularly attractive for a high income person who is within 10 years of retirement. If the participant is self-employed or works in a small business where the pension plan can be easily modified without affecting the benefits of other workers, then this type of retirement can be an extremely attractive way to shelter more income from taxes.

The net effect is that most individuals who are in a position to take maximum advantage of this benefit will save more than $5000 in taxes for 2004 as a direct result of the increased retirement plan limits.

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