Defined Benefit Plans and New Tax Realities of 2013: Plans Grow in Utility in Light of Tax Increases and Anticipated Changes Driven by the New Budget Proposal

The tax world has changed in 2013. The American Taxpayer Relief Act of 2012 (ATRA) introduced new tax rates for high income earners. Combined with other tax hikes, such as Medicare surcharge on earnings and capital gains, this increase will result in a potentially higher tax liability unless proactive steps are taken.  Defined benefit plans have long been used as an effective income tax management tool; with the recent tax increase and contemplated retirement account cap as outlined in the fiscal year 2014 budget released by the Administration on April 10, their advantage has increased even more.

New Taxes Effective in 2013

As covered in one of our recent newsletters, a number of tax rate increases and new taxes became effective in January.

1) Tax Increases:

a.  Maximum federal income tax rate has increased from 35% to 39.6% on income over $400,000 for single filers and $450,000 for those who are married filing joint returns.

b. Capital gains tax rate, applicable to all capital gains, has increased from 15% to 20% for individual filers with earnings over $400,000 and families with income of greater than $450,000.

2) New Taxes:

a. Individuals earning more than $200,000, families with income greater than $250,000, and married filing single tax payers with income in excess of $125,000 will pay an additional Medicare income taxof 0.9% on earnings above those thresholds. For example, assuming earned income of $500,000 that’s $2,700, $2,250, and $3,375 in new Medicare tax.

b. Individuals with income over $200,000 and families with earnings greater than $250,000 will see a new 3.8% Medicare surcharge on capital gains. With this increase, taxpayers in the above $400,000/$450,000 income category will see their capital gains rate at a new high of $23.8% (8.8% increase) and those whose income is between $200,000/$250,000 and $400,000/450,000 will face a new rate of $18.8% (3.8% increase).

Defined Benefit Plan Overview

To understand how a defined benefit plan may provide a reprieve from the increased tax burdens, it’s important to understand their nature. Defined benefit plans promise to provide a participant a monthly benefit beginning at retirement and payable until death. The amount of this benefit is usually based on years of service and how much the participant earned during his or her employment. The contribution is determined each year by an actuary as the amount needed to fund the future benefits guaranteed by the plan. Consequently, these plans provide employers with the potential for much higher contribution levels than defined contribution plans.

A cash balance plan is a flavor of a defined benefit plan. The funding limits and rules that apply to pension plans are applicable to cash balance plans. However, unlike a traditional defined benefit plan, cash balance plans look like 401(k)s. Cash balance plans establish an internal account for every participant; however, similar to a traditional defined benefit plan, all assets are pooled in one trust account. Each account grows annually from two sources: a contribution credit and an earnings credit tied to a formula specified in the plan. Similar to a traditional defined benefit plan, cash balance plan contributions are determined annually by the plan’s actuary, who calculates the amount of funding based on the plan’s crediting formula, performance of plan assets, and other actuarial factors.

How Does a Defined Benefit Plan Help?

By redirecting some of the income from personal earnings toward funding a defined benefit plan, high income earners may be able to reduce their income level below the thresholds subject to the highest tax rate exposure. For instance, a 50 year-old business owner earning $400,000 can avoid the impact of the tax increases by making a $200,000 contribution into a Defined Benefit plan.  Investing the funds in the qualified plan account will allow her to avoid the new 3.8% Medicare surcharge as neither contributions to the plan nor the eventual distributions from the account are subject to it.

Putting it All Together

Let’s consider the following case study. Mark, a 40-year old management consultant, earns $500,000 net of business expenses. Following his financial advisor’s guidance, he establishes a defined benefit plan in combination with a 401(k) profit-sharing plan targeting an annual contribution of $150,000. As a result, Mark reduces his earned income to $350,000 which allows his family to avoid the exposure to the increased federal tax rates, reduces the bite of the Medicare tax, and helps to escape the Medicare surcharge.

The impact is illustrated in the following table:

Without a Plan With a Plan
Income $500,000 $500,000
Pre-tax Plan Funding $150,000
Taxable Income $500,000 $350,000

Federal Income Tax

$177,300 $122,500

Medicare Tax Increase

$2,250 $900
Net Available $320,450 $226,600
Lifestyle Expenses $225,000 $225,000
Amount to Invest $95,450 $150,000

Overall, Mark is able to reduce his tax liability by $56,150, significantly reduce the impact of the 2013 tax increase, while setting aside $150,000 per year for retirement. Furthermore, contributions will grow on a tax-deferred basis and will not be subject to 3.8% Medicare tax when distributed unlike distributions from after-tax accounts.

For a successful business owner, defined benefit plans offer substantial advantages, including tax management, retirement security management, and risk management. With the recent tax rate increase, introduction of new taxes, and contemplated caps on retirement account balances, their utility is ever more increasing.

To discover how a defined benefit plan may help your client manage their income tax liabilities, contact your First Allied Retirement Services consultants at (888) 926-0600 or .