Financial Briefs

Doctors, dentists and business owners with more than $321,400 of 2019 adjusted gross income have one last chance not to pass up on this tax and retirement planning opportunity.

With just weeks before the end of the year, time is running out to reduce your 2019 tax bill while socking away a large sum in federally tax-advantaged retirement savings accounts. These tax breaks written and ratified by the U.S. Congress and signed by the President, and their enactment meets judicial standards. Although the government never gets credit for doing anything right, these laws provide a reliable framework for strategic tax and financial planning.

This strategy is particularly useful to professionals and business owners in their peak earning years, who have not saved enough to retire or want to jump-start the process and try to retire as soon as possible.

The linchpin of this tax and retirement planning strategy is a defined benefit (DB) plan. DB plans are tax-advantaged under federal law. This strategy is subject to the risk that the U.S. Government could become irrational and U.S. law could be less reliable and subject to change.

Past performance is never guaranteed to be the same in the future. However, America has a history of meriting the full financial faith of investors, and investors are rational to rely on federal law, which is a great strength of the United States. If U.S. law is a contract with Americans, the U.S. Government will remain faithful to federal laws, such as those treating IRA withdrawals as income and other laws exempting Roth IRA withdrawals from income tax. Assuming the U.S. keeps such implicit promises in the U.S. Internal Revenue Code, this is a highly effective strategy for putting retirement savings on steroids.

DB plans are much less well-known than defined contribution (DC) plans. It's retirement savings on steroids; a way to catch up fast on years of neglecting to properly fund your lifestyle retirement.

Professionals and business owners must spend years learning, testing, and gaining experience to be great at their chosen paths. Delayed gratification makes it common for high-income professionals and entrepreneurs to live well but not save nearly enough. A DB plan bursts savings in a federally empowered tax-advantaged account.

With a DB plan, your retirement contribution is defined; your retirement benefit is not. DC plans pose less financial risk to employers, so they are much more common. The federal tax code imposes much higher contributions than on DC plans as well as more elaborate rules because a DB plan is designed to last your actuarially-expected lifespan. DC plans are not intended to last your lifetime.

High-income business owners and professionals often find that, after their children are launched, having paid for college and maybe a wedding, a sudden glut of free cash enables stashing away a large sum and funding the comfortable retirement they have earned.

Here an illustration showing just how much retirement savings accelerates in a DB plan:

In 2019, the maximum contribution to a DB plan is $225,000 versus $56,000 for a DC plan. If a business owner has a DC plan already and now adds a DB plan, they could reduce their taxable income by as much as $281,000! If socking away $281,000 would make it impossible to meet current expenses, you can contribute less.

Consider a dentist, doctor or business owner in her peak earnings years and married. Her annual income of $515,000 is diminished by a 37% federal tax rate and high living expenses, which made it difficult to save enough for retirement. Funding a DB plan as well maxing out a DC plan lowers her taxable income and lowers her tax bracket. If this dentist places $200,000 into the retirement accounts, it would reduce her $515,000 taxable income to $315,000, putting her in the 24% federal tax bracket instead of the 37% bracket. The point is, you want to manage your tax bracket to optimize your personal situation.

Because her dental business is NOT a "C corporation," she also qualifies for a 20% deduction under Section 199A of the new tax code for owners of S corps, LLCs, sole proprietorships, and other pass-through entities. To get this extra tax break, her taxable income must not exceed $321,400 for a married couple in 2019.

If she hadn't taken steps to whittle down her high income, her taxes would be much higher. Moreover, she has socked away a large defined benefit for retirement!

Setting up a DB plan requires tax and actuarial expertise and careful planning but can be worth the trouble, especially because of the new 20% tax deduction and the opportunity to accelerate your retirement savings. But it takes time to set up your plan, and you only have until the end of the year. If you wait any longer, you will be passing up on this opportunity.

This article was written by a veteran financial journalist. While we believe the source of the information to be reliable, it is not intended to be used as financial or tax advice without consulting a professional about your personal situation. Tax laws are subject to change.