Starting a one person pension plan

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Starting a one person pension plan

by Tony Novak, CPA, MBA, MT
last updated on 10/20/2012

High income self-employed individuals can save tens of thousands of dollars on income taxes each year by setting up their own pension plan. These plans allow taxes to be avoided on hundreds of thousands of dollars of income- up to about $4 million over a working career – by transferring some pre-tax income into a retirement plan account. In contrast, traditional retirement plans like 401(k), profit sharing and Keogh plans typically limit the tax deduction to only about $42,000 per year. A maximum tax-deductible pension plan contribution can be many times larger than the maximum 401(k) plan allowance, often reaching hundreds of thousands of dollars if desired.

“A maximum tax-deductible pension plan contribution can be many times larger than the maximum 401(k) plan allowance… These plans are especially popular with realtors, general contractors, physicians, attorneys and accountants.”

While pension plans are available to any business, they are especially popular with one person businesses. This is simply because 100% of the plan’s cost goes directly to the business owner’s investment account. These plans are especially popular with realtors, general contractors, physicians, attorneys and accountants. Recently a number of other health care professionals including physical therapists, optical professionals and nurse anesthetists and real estate related occupations including architects and remodelers) have used these plans as their incomes grow in the current economy.

Most small business pension plans are “insured plans”, meaning that they are exempt from many of the more difficult requirements of the IRS and Department of Labor. These are also known as “412(i)” plans named after thee section of the Internal Revenue Code that permits the more liberal management. A more descriptive name is “Target Benefit Annuity Plans”. These pension plans are easy to start and operate when the business owner has a clear understanding of the options available. When the options are selected, the plan can be started within one business day. The plan paperwork must be completed before the end of the tax year. The first year’s contribution must be made by the due date of the business tax return.

Step 1. Estimate the amount of the intended contribution.

Planning often starts with estimating the amount of the current year tax-deductible contribution that you would like to make. This might seem like “backwards planning”, and in fact it is. But the amount of the immediate tax deduction available is often the most important factor to the individual planning the pension. The amount should be more than $50,000 to make this approach worthwhile, in comparison to other options (like 401(k)s) available for smaller annual contributions.

“As a practical matter, one person pension plans work best when the intended contribution is in the $100,000 to $200,000 range.”

The upper limits of contributions are controlled by the limits set by the IRS for maximum benefits that can be provided by a qualified pension plan. The limits for 2012 are publishedhere on the IRS Web site and are modified each year.

If the employer is a C corporation then the maximum pension corporation will be a lower percentage of the total business income because a C corporation must pay a salary and the pension contribution separately. An S corporation, in contrast, can use all parts of the net business income as potential pension contribution.

As a practical matter, one person pension plans work best when the intended contribution is in the $100,000 to $200,000 range. This seems to be the “sweet spot” that balances the allowable tax limitations, legal compliance issues and administrative cost efficiency.

There are many situations when a qualified pension plan is simply not the  best tool for holding higher dollar amounts intended for executive retirement benefits. In those cases a non-qualified plan is typically used to supplement the qualified pension plan.

Step 2. Verify that you can sustain this plan

Your income level should be more than the amount of the contribution, and should be fairly consistent. It helps to incorporate a three year history and a best estimate of five years into the future into your pension planning discussion.

One person pension plans are typically designed with the “safe harbor” assumption that the plan contributions will continue for five years. This is not an absolute requirement since situations change in real life and business, but it helps with the planning process.  If you were unable to fund the plan in the second year, for example, the IRS might be suspicious of your motives in starting the plan.

Pension plans used to fund large contributions for a year or two and then dropped face audit risks. The plan could be deemed to be an abusive tax shelter and not a legitimate benefit plan.

Step 3. Determine spousal benefits

A pension plan can provide benefits for your lifetime or the lifetime of you and your spouse. It is up to you. A joint-life plan costs more to fund and therefore generates a larger tax deduction.

If your spouse is an employee, then a separate benefit can be established for him/her. (We typically consider businesses where the husband and wife are the only employees to be “one person businesses” for benefits planning purposes based on the presumption that there is a single and controllable interest and common financial goals).

Step 4. Determine retirement age

The IRS allows early retirement age at 55. Again, this is up to you. Earlier retirement age increases the plan cost and therefore results in a larger tax deduction.

Older individuals considering starting a new pension plan should consider whether they are likely to work for at least five years. If not, special attention is needed for the short funding period of the pension plan.

Step 5. Decide if You Want Insurance

The pension may be insured in the event that you become disabled or dies before retirement age. In either event, insurance allows the plan to continue as originally planned. If you are single or your spouse is financially independent, insurance makes less sense. Insurance increases the plan cost but might not increase the tax-deductible amount because insurance costs are generally not tax-deductible.

Insurance may be included inside the pension plan and small amounts of insurance often make sense. But it may make more sense to keep large insurance policies outside of pension plans. Large amounts of insurance included inside a pension plan may raise audit risk and the IRS is focusing on these plans as a high priority audit target.

Step 6. Decide on the Investments

Almost any investment may be used inside a pension. I prefer to “keep it simple” with a diversified portfolio of stocks, exchange-traded funds and/or mutual funds. I have been a long-time fan of using Vanguard as custodian but many other firms provide equally qualified service.

Less common investments like gold, real estate and commodities significantly raise pension administration costs and audit risk. These higher costs, in turn, reduce the long term effectiveness of your plan. My simple advice is do not use these in a one person pension plan.

Insured pension plans, as the name implies, are funded with insured investments. This takes away most of the characteristic guesswork and variables in most other types of investment securities. Plans funded with traditional insured products include a built-in commission and usually have no separate administrative charges. If you select no-load investment products, then fees are paid separately. Sometimes, but not always, a better investment is available as a no-load. You should compare both options. This decision is not as difficult as it seems; just focus on your expected net rate of return after all plan expenses are paid.

The combination of start-up and administrative fees are usually about $600 for an insured plan and about $2,000 for an uninsured plan in the first year. The cost may be lower in future years if the plan remains stable.

We always suggest that you limit total overall investment account charges and fees to no more than about 1.2% of your account balance. If you select no-load investments without added asset management fees then this is easy to accomplish.

Step 7. Check the Assumptions

You, as the business owner, are ultimately accountable to the IRS to show that the pension plan is a reasonable business expense. This means ensuring that the assumptions used are realistic. Interest rates and all other assumptions should be within the range permitted by the IRS.

Step 8. Sign the Plan Documents and Open an Account

Assuming the plan was designed with an actual financial product in mind, just make sure that you execute the plan documents and open an investment account with a minimum deposit before the end of the year.

If you elect to serve as the trustee of your own pension plan, then you may need to add an ERISA bond to your commercial insurance package. This typically costs $200 to $300 per year. Your insurance agent will be able to provide details.

After the pension plan is established and the investment account is funded, the plan is basically self-sufficient until the end of the year, when all of these factors should be reviewed again.

One person pension plans are usually exempt from the expensive annual audit requirements placed on larger companies. The Department of Labor provides additional guidance and a flowchart to verify your qualification for this exemption.

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