Pension plan design and contribution calculation example

Posted on Posted in Financial Planning, Retirement, Small Business

This is meant as an example of a simplified small business pension plan designed specifically to maximize tax-deductible contributions to the owner. The data is based on 2004 tax law; the results may change slightly in future years. This is an “extreme” example that would not be used in most tax-qualified health plans. Most pension plans will use more moderate assumptions. The actual assumptions and deductions will vary depending on actual circumstances.

Assumptions:

The maximum annual benefit the pension plan may provide is $165,000. (This amount will increase each year).

Current age is 45.

Life expectancy is age 97.

Early retirement age is 55.

Number of year to retirement is 10.

Number of years of pension benefits is 40 (Calculated as 95 minus 55).

Interest rate is 3.5%.

Compensation for each of the past three years is $500,000 that is not needed for living expenses.

The business has no previous pension plan.

The financial planning goal is to maximize the current tax deductible retirement plan contribution.

Calculation:

Maximum target account accumulation at early retirement age is $3,523,587. (This is the investment goal).

The first year contribution to fund this benefit is $300,355. (This is the maximum annual tax deductible contribution. The contribution amount may stay the same in future years if actual financial results are the same as the expected results. A deviation in actual results may change the contribution in future years).

Online retirement calculator

Yahoo Finance offers an excellent free and easy-to-use financial calculator that handles the retirement plan contribution calculation for most common situations. The calculator has a limit of 40 years of retirement income so it may not be used when the expected retirement age is 55 and the life expectancy is greater than 95.

A calculation of the maximum allowable tax-deductible contribution is available as part of my tax planning consultation service. This calculation is an estimate; the actual allowable amount is based on an actuary’s report.

Additional resources

Pension plans for small businesses

Target benefit annuity plans

412(i) pension plan suitability

Update on 412(i) pension plans: Use of life insurance and annuities in small business pension plans

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