For a retirement plan to be qualified, it must be designed for the benefit of

John Fitzgerald, CPA

7.26.21 | Berdon Vision

The headline in the lead editorial of the April 8, 2021, Wall Street Journal states: “New York Taxes Go Skyscraper High.” This is not unique to New York. Other states, for example California, also have significant state income taxes. Furthermore, the Biden administration is looking to increase Federal income tax rates.

This, along with other reasons, is why, when meeting with current or potential clients, one of the first questions raised is: “How can I reduce the income taxes I am paying?” When asked this question, our reply to the client is to consider implementing a robust qualified retirement plan. While there can be exceptions to following through with such a plan, let’s explore why this response, in general, makes sense.

What is a Qualified Retirement Plan?

A qualified retirement plan is recognized by the Internal Revenue Service where investment income accumulates on a tax deferred basis. A qualified plan meets the requirements set forth in Internal Revenue Code section 401(a). There are several types of qualified retirement plans, including defined contribution plans, such as 401(k)s, and defined benefit plans. Qualified retirement plans may own a variety of investments, including stocks, mutual funds, and bonds.

Defined Contribution Plans

A defined contribution plan includes a 401(k) and profit sharing plan. Under, for example, a 401(k) plan, an employee is allowed to contribute a percentage of wages earned to the qualified plan each year, while the employer may also choose to contribute a percentage of wages paid to an employee. Early withdrawals are allowed before retirement in a 401(k) plan; however, the employee must meet certain requirements to avoid paying a penalty on such withdrawals. For the calendar year 2021, the maximum annual contribution amount that can be made to a participant’s account is $58,000. The maximum annual contribution amount if the participant is age 50 or older by year end is $64,500.

Defined Benefit Plans

This type of plan is not as common as a defined contribution plan. In this type of qualified plan, the employee is promised a certain amount of money due at retirement, and it’s the employer’s responsibility to fund this benefit. At retirement, the employee can either choose to receive an annuity (i.e., a fixed monthly payment) or a lump sum amount. For the 2021 calendar year, the maximum annual benefit that can be paid to a participant under a defined benefit plan is $230,000. In determining the annual contribution allocations to a defined benefit plan, a plan cannot consider any employee compensation in excess of the “annual compensation limit”; for 2021, that limit is $290,000. Since a defined benefit plan is designed to pay an annual benefit (i.e., an annuity) to the plan participant, the annual contribution (and therefore tax deduction) can be up to approximately $300,000, depending, in general, upon the age of the participant and when the participant entered the defined benefit plan.

Why Should I Implement a Qualified Retirement Plan?

While businesses are not required to implement a qualified retirement plan, such plans can provide benefits to a business owner that typically outweigh the associated costs. Some of those benefits are enumerated below.

• Qualified retirement plans are government sanctioned tax shelters. As long as the requirements are satisfied, there is no risk that the government will disallow the benefits if an audit occurs.
• Offering such a plan may improve employee recruitment and retention.
• Qualified retirement plans allow employees and business owners to accumulate earnings on a federal and state tax deferred basis. In addition, depending on where the recipient of the qualified retirement plan payment lives when payment is made, the payments may be free of any state income taxes (e.g., if the recipient lives in Florida).
• Generally, qualified retirement plans are exempt from creditor claims.
• Employers receive a current tax deduction for payments made to a qualified retirement plan for the benefit of employees; however, the employee does not report the corresponding current income. The income is recognized when the employee receives distributions from the qualified retirement plan. For the employer, this helps to minimize the employer’s current income tax liability.
• Qualified retirement plans can help business owners and employees amass a significant amount of money for retirement. This will provide employees and business owners with the ability to work in their later years because they want to work, not because they have to work.

Why Lock it Away?

When deciding whether or not to implement a qualified retirement plan, we are typically asked: “That is a significant amount of money that I will not see for many years, so why should I do that?” Our reply is that a significant portion of the amount paid as a contribution to a qualified retirement plan would never be seen by the recipient because it would be paid to the government as income taxes. As we all know, once paid to the government, you never see the money again. A qualified retirement plan allows the recipient to keep the money that would be paid to the government as income taxes and derive earnings on that money on a tax deferred or tax exempt basis. When clients hear that, we are normally told to set up a meeting so the business owner can learn more about implementing a qualified retirement plan. Those meetings typically result in the client deciding to implement such a plan.

Conclusion

As you can see, qualified retirement plans can provide significant benefits to both the employer and the employee. However, before a decision is made to implement a qualified retirement plan, it is necessary to evaluate the benefits and the costs. In our experience, the monetary and intangible benefits usually outweigh the cost involved.

See the example set forth in the case study below, which illustrates how a qualified retirement plan can enable the participant/sponsor to set aside tax deferred, and possibly state tax exempt, funds and reduce current tax liabilities.

Qualified Pension Plan Case Study

Assumption:

Married partner age 62 with taxable income of $650,000 before implementing a qualified pension plan. The analysis below is based on 2021: (1) federal tax rates and (2) pension contribution amounts. Additional benefits may be available if state and local taxes are applicable.

*As noted, this is the maximum that can be contributed annually to a defined benefit plan based on the facts as stated. It should be noted that a defined benefit plan can be structured so that the amount contributed is less than the amount shown in this chart.

Questions? Contact John Fitzgerald at 212.331.7411 | or reach out to your Berdon advisor.

Contributing author: Saul B. Brenner CPA, J.D. and LL.M. (taxation)

Berdon LLP New York Accountants

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