Pension Maximization: Reducing the Taxes Owed to Uncle Sam!

Posted on October 3, 2011 by Bill Faiferlick

Why you need to consider a hybrid pension?

Effectively reducing or eliminating your tax liability , the single largest financial obligation confronting business owners and professionals ( which yields no financial return and  strips needed capital from your company), is one of the most efficient actions you can initiate to gain better control over your hard earned income. Your tax status needs to be at the top of the list. Pension maximization can immediately increase the available capital needed for investment and long-term planning initiatives. This is new found capital that you would otherwise be paying in taxes.

Taxable deductions result from pension planning

An integrated financial strategy provides greater efficiency and effectiveness by providing tax deductions or write-offs that allow you to invest your tax liability into a pre-tax investment vehicle for your benefit which can accumulate notable sums in even a short period of time from $80,000 to $350,000 annually.

Too often the focus is on immediate requirements at the expense of long-term goals or needs. You already write off as many expenses as possible, so why not write-off a hybrid pension contribution which works to freeze existing company paid employee contributions while ratcheting up your contribution four to six times over current levels?

Pensions offer protection and safeguards from judgments and creditors

Pension assets are protected from judgments and creditors by federal law. They offer protection guarantees not available with typical non-sheltered investments. Reducing your risk allows you to focus on wealth accumulation knowing you’ve erected a barrier to those who would seek to take your success from you.

Beware of risky recommendations which tend to focus on code sections

Some advisors or advisory firms are currently focusing on code sections which require little if any formal governmental filings or oversight. They market a variety of services or products as solution based opportunities referring or quoting parts of code sections to unsuspecting business owners and professionals.

Whenever one of the main benefits emphasized is that there are no required government filings rarely do these “opportunities” stand up under the scrutiny of the Internal Revenue Service once these mass marketed applications have acquired a certain degree of notoriety.

The financial services industry is littered with collapsing “opportunities” that leave the client with untold tax liabilities, fines, audits, and typically the loss of invested capital as the benefits within the particular products are rarely capable of producing the financial results when regulatory compliance or oversight is enforced. There are legitimate opportunities with little required governmental oversight or filings; however, special care and greater understanding needs to be exhibited when considering these beneficial programs.

Stark contrast in recommendations

Every opportunity has pros and cons and the following solution is making its rounds at the moment. In this scenario, the advisor is combining mainstream products to shape them into a reasonable solution. This will work put they’ve missed the point because as you will see the client is still paying $20,000 more each year in unnecessary taxes than they need to if the advisor had been able to design a plan which would have taken the entire contribution.

The pitfall of 401(k) catch-up provisions and annuities using after-tax income

A common approach is to recommend a 401(k) with a catch up-provision which increases the owner’s contribution for a total deductible contribution of $45,000 (in a 401(k) plan).

At face value, this is an attractive provision commonly recommended except that the contribution still isn’t of sufficient magnitude for most business owners or professionals.  To supplement the plan, an after-tax annuity product (for tax-deferred growth) of another $30,000 is added to bring the total combined investment to $75,000.

This creates a combination of pre-tax and after-tax investments.

This may sound attractive on paper; however, the issue is the $30,000 annuity after-tax investment requires pre-tax earnings of $50,000 minus taxes of $20,000 before the $30,000 annuity investment is permitted.

The $30,000 annuity costs the business owner in real dollars $50,000. Granted the annuity’s growth is tax-deferred but the participant’s tax liability hasn’t been effectively dealt with therein reducing the overall effectiveness of the recommendation providing the objective is to reduce tax liabilities and maximize investment accumulations.

This defeats the overall objective of utilizing the tax system to the fullest advantage to accelerate wealth accumulation.

With employees, catch-up provisions may increase employee costs and often offset other benefits

Assuming the company has at least two employees, the required employee costs to the company will be in the form of pension contributions especially once the catch-up provision in the 401(k) is adopted.

The increased company-paid employee contribution will more than likely eat up the increased tax savings to the owner making this a zero sum game.

This zero sum game has other consequences for the owner

If the company finds itself unable to maintain the high employee contribution, it will have an impact on employee morale and retention.

Cutting back or reducing employee benefits which they have become accustomed to or rely on is often one major factor in internal discontent.  The consequences of reducing employee benefits can suck the life out of productivity at a time the company needs increased productivity not vice versa.

Key employee benefits with off-the-shelf programs can be costly

There is a major distinction between key person benefits and employee benefits. Key person benefits are necessary in some organizations. These benefits need to be carefully executed to minimize rank and file expenditures; otherwise, the overall effectiveness of the strategy will be compromised.

Off-the-shelf recommendations or products seldom provide maximum efficiency for key person benefits. These packaged solutions generally require some form of rank and file employee consideration providing the opportunity falls well within all regulatory rules and compliance modeling and can increase the overall capital costs to the company.

Hybrid plans create benefits needed by owners while simultaneously minimizing employee costs.  Instead of catch-up provisions and an annuity, it would have been  more effective for an owner to implement an IRS approved owner benefit plan with the owner participating in a hybrid pension plan. This scenario produces an immediate fully deductible contribution of $75,000 saving the owner $20,000 (the after-tax annuity contribution discussed in the example above).

 Hybrid pension plans provide stipulations and investment guarantees

This model is not complete unless the plan provides certain internal provisions (often specified within the plan document) which stipulates certain guarantees and investments. These types of stipulation are crucial if market volatility and return of principal and investment gain are concerns.

Many of us have experienced the effect of market volatility which can virtually wipe-out not only anticipated or expected gains but reduce account values to a level which can take a decade to regain.

For anyone in their mid-fifties or older, guarantees on contributions, given the economic uncertainties, provide reassurances that deferred income and growth will be available as planned.

Immediate returns available with pension planning

When the strategy converts the $30,000 contribution (from the example above) into a tax-deductible contribution, this immediately provides a saving of $20,000 that would have been paid in taxes. Due to the elimination of the $20,000 tax, the investor is already tens of thousands of dollars ahead of any after-tax model. Add to this the internal deferred compounding  and the accumulation effect will be amplified. Make this contribution and tax savings (which is about 45% of your contribution) work for you over the ensuing years and this will provide another level of security which you would not otherwise have. Since this account value far exceeds any after-tax scenario, this permits the plan to assume less investment risk providing more financial guarantees.

Retirement higher tax-rate fallacies

If you believe that the value of deferring money is less than beneficial because you will be in a higher tax bracket when you retire or withdraw the funds, this, in fact, is seldom the case. Despite this assertion by many CPAs, the reality is that this account may only account for about $3 million of your overall net worth. Considering you’ll need $7 million if you expect to have a $200,000 yearly income, you must do more to accumulate additional capital. As a starter this is certainly the most efficient strategy since the government is contributing about 45% of your total contributions (tax savings) if acquiring wealth is truly your objective.

The second goal is to diversify your investments once you’ve established a savings/investment pattern to invest other monies with the objective of this segment of your portfolio being treated for tax purposes in the 15% bracket. As a percentage of overall income, few wealthy individuals have a majority of their income taxed at the earned income rate.

The greatest share of their income is typically structured in such a way that the lion’s share is taxed at the lower capital gains rate of 15%. They will, just as you will, have income taxed at ordinary rates but an account with $3 million will not put you into the highest tax bracket. It will, however, diversify your income for life once you retire.

A great example of this is Warren Buffet. He’s repeatedly been outspoken regarding this issue saying that many of his rank and file employees pay much higher taxes than he does because he’s only referring to his earned income. The majority of his income is structured and taxed at the 15% rate.

Your entity structure selection does impact your tax savings benefits

Your tax status and the corresponding entity structure(s) have a direct correlation on the type and size of tax savings available to you. Additionally and no less importantly, entity structures also directly affect the risk management or asset protection component in your particular strategy.

Today, more than ever other considerations such as risk, market volatility, asset accumulation, partnership expansion or contraction, growth of the company or practice, profitability, selling the business or practice, multiple entity usage and numerous other considerations are all affected by the type and scope of the entity or entities you’ve chosen to maintain and the type of benefits you seek to include given your lifestyle, personal responsibilities, and unique business needs. Gone are the days of adopting a C or LLC status company because this is what is commonly recommended by most CPAs.

Comprehensive strategic plans are the foundation to wealth

Incorporating integrated strategic planning enables business owners and professionals to leverage the tax system utilizing the most effective, legitimate opportunities available. This assures your money is working at least as hard as you are by aligning your priorities, goals, unique objectives, and other personal considerations with non-performing business assets and appropriate business structures to unify your initiatives.