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My wife and I are thinking about switching to a DB plan. With our ages


Guest sampat

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Hi,

I run a small company with three employees. Two of them are myself and my wife and third is a non-us citizen. We currently have a money purchase and profit sharing plan (25% contribution limit). We are not happy with the tax deduction we are getting. I was recommended to start a DB plan. With our ages of (42 and 39 respectively) and salary of $55000 for both of us, what is the maximum contribution I can make to a defined benefit plan on a tax-sheltered basis?

Would I be able to eliminate the non-US citizen employee from coverage to thsi plan?

Would by existing money purchase/profit sharing plans need to be terminated and rolled into IRAs.

Sampat

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Based upon your ages, I think it's unlikely that a DB will be much if any better for you, but a couple of additional items would be helpful.

First, is your company a corporation or a proprietorship or partnership? Is the $55,000 a total income figure (i.e. W2 or just base pay, and if base are there bonuses?). If not W2 income, net Schedule C or K1 income would be needed.

Is your past income greater or less than your current income? If greater, a 3 year average would be helpful.

In my experience, DB plans produce higher deductions at around age 45 or higher, but it all depends upon the assumptions that actuaries are willing to use, which will differ.

I don't know the answer about the non-citizen question, but I can tell you that the inclusion or exclusion should be the same whether it is a DB or a profit sharing or money purchase plan. Is this person being paid U.S. dollars for work here, or for work in another country?

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Guest PAUL DUGAN

I agree with ANDYH (2nd time today) that age 45 is the magic age for a DB but there may be a way to make a DB pay. If you can adjust salaries. If you can change compensation so that the older of you or your wife draw a much larger salary for 3 years then start givin other the larger salary in year four you should be able to be able to increase your contribution by approx 2X. This will only be a good idea if the employee is younger or has very little past service compared to you and your wife.

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Paul and Andy,

Thanks for your information. MY three year average salary for past three years was $42000 and my wife was only employed by my company for two years with average salary of $42000. Now the new salary for both of us could be $55000.

The other employee is paid in US dollars and is on temporary worker (H-1B) visa here.

Some benefit's company indicated that I would be able to contribute $79000 and my wife $50000 per year to a DB plan. However, I am not very sure that is why the question to the board here.

Won't the repeal of 415e starting this January help me in getting more tax deduction.

See:

http://cnnfn.cnn.com/2000/12/18/cashflow/q_bizretire/

Sampat

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I also agree with the others that at about age 45 the DB contribution generally would exceed the DC max (assuming pay of > $170,000) BUT, just because the DC contribution is > than the DB, doesn't necessarly mean that it should not be considered. With the repeal of 415(e), you can have both.

What normally happens is that since if you keep both (DB & DC) your combined deduction would be limited to 25% of covered payroll, which generally isn't enough to justify the added expense of the DB plan.

We have put a few "cash balance" type plans in for Dr. groups who wanted to max out at the 25% limit, but you generally need more than 1 highly paid person to make it work from a benefits vs. expense perspective.

Also, the 79,000 and 50,000 sound way to high to be justified, but you never know. I'm sure there is some great insured product that will work wonderfully! Maybe a future post will enlighten us - he says w/sarcasm!.

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Keith's comments about the contribution levels echo my thoughts precisely. Somebody's selling you something you don't want.

I want to defer to the actuaries on this Board for the contribution levels, since the maximum deduction will depend upon how aggressive an actuary is willing to be.

Having said that, I think you can get a deduction of no more than 1/2 your salary, and that's by using either aggressive assumptions or a funding method which front-loads the costs, which creates a potential risk.

You should be able to get a deduction in excess of the 25% limit applicable to your existing plans, the question is how much above, and whether it is worth the risks and the expense. My advice is to consult with an actuary who does not sell anything.

If you went with a DB plan with a contribution exceeding 25% of pay, I'd advise you to terminate the money purchase plan, and probably the profit sharing plan as well, but I'd probably keep that inactive for a couple of years, in case the DB contribution goes below 25% or payroll, in which case you could fund it. Your maximum deduction would be the greate of the DB required amount or 25% of eligible payroll, and the profit sharing contribution alone would be limited to 15% in any event.

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I would agree that the 79K ctb level for a 42 yr old probably has some kind of insurance product to increase the ctb.

However, I tend to disagree with earlier comments in that I think a ctb of 75% of comp (or 42K or so) can be provided in a DB plan for a 42 yr old using acceptable actuarial assumptions (I happen to be 42 and did a study for myself recently). I don't think it is purely a matter of opinion what is aggressive and what isn't, since this can be based on audit experience, audit guidelines, the multiple tax court cases that the IRS lost when they challenged truly aggressive assumptions, etc. Certainly the assumptions I used were not "substantially unreasonable" in the sense of the court opinion. Also, I tend to think that when an actuary says something is risky or aggressive, they often fail to mention the risk is 1 in 1000 or smaller and the worst case scenario is not that bad!

I would also add that the 55K comp from the S-Corp must be W-2 on which soc sec tax is paid, no pass through income can be counted.

Also, the age of the 3rd ee is important. If he/she is not in their early 20's or ineligible due to <1000 hrs/yr, they would get a substantial benefit from the DB plan, although vesting would help to limit this if they ended up being a short-service ee.

Another option not mentioned so far is funding both a DB and a money purchase plan at the same time using the flip-flop method of taking deductions. I have not employed this method yet but it has been discussed a lot recently. You would fund both plans and deduct 2 yrs of DB ctbs one year, and deduct 2 yrs of MP plan ctbs the next yr, etc. Using this method you can avoid the 25% 404a7 limits. However, the ctbs must be timed carefully, requiring ready cash, and you cannot extend your corp tax return.

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Thanks for all your inputs. I did talk to the DB plan consultant again, he said he will use a retirement plan for me to retire at the age 53 and use 5% return assumption. After 53 years, I will have to terminate the plan if I am still working and start at Profit sharing or other plan then. He claims that should give a combined tax deduction of $80000+ per year. I am not sure if there are any pitfalls to doing that?

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I know these are aggressive assumptions. He may have to limit me to some funds (bond funds or such) so the deduction level stays the same otherwise he will have to readjust contributions down in future years. He says he will get a letter from IRS as to the fact that plan is qualified. Once terminated. money could be rolled into IRA and I can again get aggressive with my investments.

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Sampat:

I've set up many dozens if not a couple hundred of these plans over 20 years.

I think this is a very, very bad idea. I assume you went on this message board to seek advice. My advice is, don't do this. Period. Find another consultant who either doesn't want to sell you anything or doesn't think he should limit your investment return to maximize your deductions. Bad idea. Bad advice.

This is a sophisticated arrangement you're talking about, loaded with downside risk. At your age, there isn't much upside reward. My advice is stay with what you've got till you're 45 or 46.

There are a number of complications with the situation you've described. The complications are simply not worth the tax benefits, in my opinion.

When you're ready, find somebody top shelf to set this up. I don't think top shelf people set up what you've described.

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I beg to differ somewhat. While this approach does have a lot of downside for the unsophisticated and unaware, it can be very beneficial for the sophisticated and aware. Let's face it, we are accelerating a nice tax deduction.

However, we should not minimize the downside risks. The actuarial assumptions are aggressive but potentially defensible. (My preference is generally not to assume retirement before age 55, later if possible, and to use an interest rate of no less than 5.5%. The actuary can calculate the resulting contribuiton and discuss the additional contribution versus the additional audit risk.)

The plan will likely be overfunded on an accrued benefits basis for the next several years. Therefore, if something goes wrong with your business and you want to terminate the plan before you turn 53 or 55, you probably will have more assets in the plan than the value of your benefits -- this would incur a large excise tax on the excess.

The cost of your employee must be factored into the analysis.

Also, are you prepared in the next several years to continue to make large contributions? Will your cash flow support it? There are many techniques that can be used to provide contribution flexibility, but aggressive assumptions sometimes require aggressive techniques. Your actuary should discuss this with you. Perhaps have him run some scenarios for the next several years so you can see what will result (and what he is comfortable with).

Depending on the sophistication of the actuary and your facility with numbers, this is often useful. (I've seen this done particularly with clients who are scientists or engineers; they understand this stuff fairly quickly.)

Good luck.

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Yes, I would agree with Richard. I understand Andy's point of view, but based on my experience he has overstated the situation somewhat. However, we all have had different experiences! Andy, if you have had some DB plans audited where similiar assumptions were challenged, I would be interested in hearing more about it. At this point I too don't feel age 55 retirement age assumption is necessarily unreasonable in a small plan. Also, I prefer to explain any risk and/or grey area to the client and let them make the decision, as long as my professional standards as an actuary are not compromised.

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I'm late to the discussion,but I have to agree with AndyH. I tried to duplicate the results shown, but the "best" I could do do was $62000 contribution for the husband and $44000 for the wife. I used a 5% interest assumption pre- and post-retirement, GATT mortality. I funded the full 415 $ max @ 53 (about $4400/month),and I assumed a full J&S annuity payout @ NRD. To me this is really pushing it, and I still came up $28000 short from the original proposal. It seems that there are a lot of things that should be disclosed to SAMPAT, but I bet they aren't. BTW, the values of the accrued benefits at 12/31/01 total about $80000,so this thing is overfunded from the getgo.It sounds like he' hooked up with a deduction mill. I don't like it. Remember that in deciding Wachtell Lipton and Citrus Valley Estates the Tax Court still left the IRS the ability to challenge actuarial assumption and methods in cases that were abusive. I think this fits.

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Beyond the actuarial assumptions, I'm hung up on a few things: the $55,000 salary-if we were talking about each the husband and wife with $500,000 in salary, maybe I could get by concern 1.

Concern 2 is 415. How is 5% funding going to be paid out with GATT rates between 6.63% and 5.49% over the last year. Are we gambling about decreases in the GATT rates? What if the economy sours and GATT rates rise? Then where is he?

Concern 3 is the investment return. Does anyone really believe he should put the money in low return investments just to get a deduction? What if the fund earns 8.5% or more? Then what are the deduction levels?

Concern 4 is the assumptions. If an actuary is willing to sign off on NRA 53 and 5%, maybe that's fine, but the client needs to fully understand the downside, and that most actuaries would probably not sign off on these assumptions. At least, those I've worked with certainly would not.

But, most importantly is the disclosure and education process, which seems lacking to me, as several of the posts here have pointed out as well.

Knowing what I know, if I were in Sampat's situation, it would not be worth it. Just an opinion.

Sampat, you've got some good comments in the posts here. If you were using one of the actuaries here, I'd feel much more comfortable with their recommendations. It's just that there are sharks in the water.

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A friend of mine and I were driving down the road and got stuck behind a slower car. We were in a bit of a hurry and were getting impatient. Suddenly my friend pulled over and just waited on the side of the road. I said "what are you doing?" He said, "I'm letting this guy get further ahead of us so I can drive faster!"

To me, this makes as much sense as putting money into a trust and choosing overly conservative investments just so that in the future you can take more of your money and invest it in the same overly conservative investments. Any dollar earned through investments is a dollar you don't have to contribute and therefore a dollar in your pocket. I agree that one is taxable and one is not, but even if you only get 30 cents for the dollar in your pocket, it's still 30 cents in your pocket.

I think sometimes in our desire to create plans which produce high contributions we loose sight of the of the bigger picture.

Also, I don't mean to sound harsh, but if your business is only producing enough income to pay you $55,000, where is the $129,000 ($79,000 + $50,000) for contributions going to come from?

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I think everyone agrees that the first proposal Sampat got was way out there and must have had lots of insurance products. Might as well give the money to charity for a deduction than give it away to a salesman.

Re Andy's Concern 1, in my opinion the 55K earned income does not in itself mean age 55 retirement is unreasonable. Remember that the DB plan would accumulate over 1 million for both of them by age 55, and most people can retire on 1 million. Also, the 55K is the earned income from the S-Corp, and there may be other income and income from personal sources as well.

Andy's Concern 2 is a valid point especially if the plan has to terminate early, but the GATT rates are generally not critical at the beginning of the plan's life. I would recommend that before the 415 $ limit 10 yr proration is up, say in year 7 or 8, that the GATT interest and mortality be monitored. One could then pull back on the funding, and if necessary freeze benefits, if the 5% assumption was way off. Also, increases in the 415 $ limit and perhaps updating of mortality would help this out over time. No one really knows what the GATT rate will be in 10-15 years, and 5% or so is not an unreasonable guess.

I believe an actuary could reasonably set the investment return assumption at a lower rate for the first 2 years regardless of the type of investment, then revise the assumptions based on experience. Going to 8% would certainly lower the contribution, but unless the FFL applies he is still much better off than with a DC plan alone (and the DC option is always there for him). He doesn't have to limit his investments for the plan to work for him; that said, it can happen that investments do so well that future contributions just don't happen as expected and create real problems. [i set up a plan 2 yrs ago and only 10K was contributed in the first year. Now he has over 225K in the plan just by investment return! I can only hope the 415 proration catches up with the assets.]

My personal opinion based on the well over a hundred DB takeover cases I've had in the last few years is that most small plan actuaries do a poor job of being advocates for the plan sponsor or communicating the complexities of a DB plan. This often occurs because they are not working directly with the plan sponsor, or, because they assume a role of giving conservative black and white options when there are really shades of grey.

Has anyone had any recent experience with actuarial assumptions challenged during audit? This would be very useful for our discussion.

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David,

I certainly respect your opinions and your comments. I have never been through a small plan actuarial audit. I and the actuaries I have worked with happened to think that the IRS had a point, to a limited degree, so we did away with all 5% preretirement interest rates, and COLAs, J&S funding, etc. many years ago. Plus, it just wasn't worth the business risk.

I agree that nra of 55 is defendable in some cases. I just think that people making $55,000 retiring at age 55 (not to mention age 53!) is a tough argument.

A comment stands out in my mind that came up at a conference years ago that I did not attend; it's second hand information, but I was told that an IRS official made the comment that if a sponsor can only earn 5% long term on money in a (then) 8% treasury environment, he'd say they had breached their fiduciary responsibility. I can't argue with that, even now.

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Since sampat is essentiallly gathering opinions here, I will add mine to the mix.

1. If you could explain to me how to make $129,000 of contributions out of $55,000 of earnings I would be interested in that program.

2. The 5% assumption is certainly aggressive, and suppressing the investment returns to justify that assumption is mind boggling.

3. Many (actually many, many, many)years ago, I did a valuation for a 30 year old with retirement at age 35 (the 415 limits were different then). The participant was a commodities trader and the burnout rate was so high that retirement at age 35 was justifiable. To the best of my knowledge, it was never audited. But is age 55 justifiable in this situation? If not, the possible deduction drops rapidly.

4. This will be a high maintenance scheme, and it seems to me that much of the potential deduction will be for expenses.

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This has been a good thread. Some good insights for Sampat, and some good discussion among practitioners.

Side comment. I once used an assumed retirement age of 28 for a boxer. My justification (to my boss, it never came up with the IRS) --- "I saw his last fight!"

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All,

Thanks for the interesting discussion and advice. In the mean time, I had a meeting with the actuary and he has come out with lower dedcutions close to 80-90K for both combined now.

However, I am seriously looking into just continuing with Defined Contributions (25% limit) till I get older. That allows me more aggressive with my investments for next several years and then switch-over to DB plans. I may get higher contributions just by increasing our salary. I was just trying to avoid some Social Security taxes. But it appears it is better to pay SSA some more than get trapped into exteremely conservative investments.

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Sampat, I am late to this, but I wonder why you (or your wife) don't take all the income. Your w-2 wages are less than 120,000 so if one of you takes all the income, the various formulas (e.g. integration) will enable you to skew the plan more towards "the family" and at the same time you would save payroll taxes on the duplicated income below social security wage base.

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Bill,

I like your suggestion.

So one of us (me -- being older and male) takes all the w-2 income (say 120K) and pay SS taxes for 80K and I would be able to set deduction for 25% in Defined contribution (30K) and set up a DB plan for any additional deductions (415e repealed!). With decent actuarial assumptions, what would be maximum tax deductible contribution to a DB plan I can make? Anyone else has other suggestions?

Thanks for the tip!

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