Want a $2 Million IRA in 10 Years?
A core tenant in financial planning is to focus on the controllable. For most of our clients, how much they contribute to their savings while working, and how much they plan to spend in retirement, have the greatest impact on the success of the plan. Investment returns matter as well, but to a much smaller degree than most people realize, and the returns are unpredictable in nature. This is of course in stark contrast to what is most often written about in financial publications – which is the next “hot” investment idea.
For many individuals, retirement plans account for a majority of their non-residential assets. Most of these assets are held in individual retirement accounts (IRAs) and defined contribution plans (i.e., 401(k) and similar plans). Defined benefit plans, also known as pension plans, make up just a fraction of the assets held in the more common vehicles. As of June 30, 2023, IRAs and 401(k) type plans had asset totals of $13 trillion and $10.2 trillion, respectively, according to the Investment Company Institute. Private sector defined benefit plans only held $3.2 trillion. Businesses have voted with their feet, and clearly have favored IRAs and defined contribution plans over the past several decades.
The perception, of course, is that defined benefit pension plans are anachronistic, expensive to maintain, and risky for the business. This sentiment can certainly be true for medium and large organizations. However, many sole practitioners and owners of small companies with just a few employees can greatly benefit from these plans. For those small business owners who are already fully funding a 401(k) or SEP IRA, we feel there is opportunity to further maximize retirement savings while also reducing current tax liabilities.
A defined benefit (DB) plan allows for much greater pre-tax contributions than defined contribution plans. Annual benefit limit for DB plans is $265k in 2023, not to exceed 100% of compensation. The lifetime maximum contribution one can make to a DB plan is an actuarial calculation. However, a business owner in their 50s can expect to contribute upwards of $2.5m over the life of the plan (source Pension Associates) – typically over a ten-year period.
Over the same ten-year period from the defined benefit scenario above, between $660,000 and $735,000 can be contributed to more traditional qualified retirement plans. That’s a significant difference. There is of course a downside to defined benefit plans. They require annual contributions, whereas defined contribution plan contributions are generally elective each year. Defined benefit plans also have higher up front and annual costs than 401(k) and SEP IRA plans. On balance, for high earning small business owners, the significant increase in retirement savings makes defined benefit plans worth exploring.
A plan design that has worked quite well for a few of our clients is a combination of a defined benefit plan and a 401(k) plan. The goal with this plan design is to maximize the retirement contribution for the business owner, lower the tax liability, and provide a benefit to an employee (if applicable) through the 401(k). In one recent example, a small business owner had a single employee and was already fully funding a SEP IRA plan. With the combination plan design, the business owner has increased his annual retirement contributions to over $100k/year. Over the next 10 years, he’ll likely contribute over $1.2m into the defined benefit plan – which is about double the contributions he would have made through the SEP. The larger retirement contribution also increases the tax deductions significantly. His employee is taken care of through profit sharing contributions to the 401(k), rather than through the defined benefit plan.
Please reach out to your West Financial relationship manager if you’d like to explore defined benefit plans in more detail.
Read the November 2023 Financial Planning Focus:
- “Don't Look Now But 2024 is Just Around the Corner” By Brian Horan, CPWA® »
- “Financial Planning 101 – Debt Management” By Matt Armendaris »
- "College Savings Account Primer” By Angel Irazola »
West Financial Services, Inc. ("WFS") offers investment advisory services and is registered with the U.S. Securities and Exchange Commission ("SEC"). SEC registration does not constitute an endorsement of the firm by the SEC nor does it indicate that the firm has attained a particular level of skill or ability. You should carefully read and review all information provided by WFS, including Form ADV Part 1A, Part 2A brochure and all supplements, and Form CRS.
Certain information contained herein was derived from third party sources, as indicated, and has not been independently verified. While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any information presented. Where such sources include opinions and projections, such opinions and projections should be ascribed only to the applicable third party source and not to WFS.
This information is intended to be educational in nature, and not as a recommendation of any particular strategy, approach, product, security, or concept. These materials are not intended as any form of substitute for individualized investment advice. The discussion is general in nature, and therefore not intended to recommend or endorse any asset class, security, or technical aspect of any security for the purpose of allowing a reader to use the approach on their own. You should not treat these materials as advice in relation to legal, taxation, or investment matters. Before participating in any investment program or making any investment, clients as well as all other readers are encouraged to consult with their own professional advisers, including investment advisers and tax advisers.