Defined Benefit Planning Referral

[Guest firstq]

Folks - I am interested in getting some basic info on this plan and perhaps a good referral as well.

Q: I am independent contractor in IT and had income in 2001, 2002 and perhaps in 2003 - but not sure about future years, it could be zero in 2004.

1. In this situation, does a DB plan make sense/allowed (not surity of income in future years)?

2. What happens when the business is terminated, money rolls over to IRA?

3. What are the annual costs of administering such a plan (going with an admin is recommended? as oopsed to DIY - services of an actuaty needed, right?)

Thanks for any help

[Guest Keith N]

All of your questions are very good, but they are not the type of thing that can be easily addressed on this board. I would recommend that you ask your attorney or accountant the questions or ask them to refer you to an actuary. If they aren't any help, if you tell us where you are located, I'm sure someone on this board can recommend someone in your area.

DB plans do have a "permanency" requirement and should be intended to be permanent. That being said, if your company is no longer making money, than you have a good business reason to terminate the plan. If you only anticipate having income for a few years, you will need to look at the higher deductions available verses the higher expenses. You may find that the db plan is a great deal, but if it only exists for a few years, the expenses involved offset the advantages. Your age and income is also critical. The older you are, the higher the available contribution.

The money can be rolled over to an IRA like any other qualified plan (PS, 401(k), etc.)

Hear in the Northeast, a one life DB plan will probably cost around $1,000-$2000 per year in actuarial fees. The attorney will charge between $1,500 - $2,500 to set it up, plus $2,000 to $3,000 to terminate. You may be able to find a cheap actuary and a prototype document for less, but you tend to get what you pay for in this business. Stay clear of insurance salesmen bearing gifts.

[Guest firstq]

Keith - thanks for your reply

I am in Phoenix, Arizona - any referrals would be helpful.

[AndyH]

Yes, that is good advice, but if you would tell us your age and approximate income we might be able to rule in or out a particular type of plan, i.e. point you in the right direction.

[Guest firstq]

33 years, 0-250K dpeending on the year

[AndyH]

My opinion is that you are too young for a DB plan. Set up a profit sharing plan and put away $40,000 per year. Look at a DB plan when you reach age 40.

[Guest firstq]

The goal was to save some money into the plan pre tax, then if the business does not work out/last after 3-5 years, dissolve it and role it over to IRA.

Not interested in keeping it for the long run - I am assuming that the business may not run long - few years, would be interested in putting more thant 40K (if possible).

[AndyH]

Understood. But the only way you can put away more than 40k is if it is actuarially required in a DB. And you need to be older for it to be actuarially required, at least under mainstream approaches. So the math doesn't work.

[Guest firstq]

One actuary I discussed with looked at all the specs and was able to come up with close to a 80-90 number -

I hope he knows his stuff.

[Blinky the 3-eyed Fish]

That actuary is on crack. I am in Phoenix also and have a guess as to who told you that.

In light of the facts below, that 2 plans are proposed and there is a spouse, I retract the crack comment.

[Guest Keith N]

I agree w/ Blinky and AndyH - sounds a little wacked.

Ask him how much insurance is in it? Ask him how much of the first year's contribution he expects to receive as a commission.

[AndyH]

And tell him the board said it's actually two retirement plans he's proposing, one for you and one for him. (Thanks again MWyatt for that line).

[david rigby]

I agree, the 80-90K is not a reasonable result for a 33-year-old. More like one-fourth of that, which is why the 40K in a DC plan is a better idea.

But, it may be possible to do both.

[mbozek]

DB plans are best suited for established businesses which will have a steady stream of revenue in order to make the required contribions each year. It is not good policy to adopt a plan solely to maximize deductions. A self employed person can adopt a 401k)/PS plan and contribute up to 40k each year or a lesser amt if revenue declines. In a DB plan the employer is required to make annual contributions to fund the plan regardless of whether there is sufficient income and the only options are to terminate the plan or reduce expected benefits. Also A DB plan is high maintence because it has more variables than a PS plan and the employer will spend more on admin and legal services than a profit sharing plan. The amounts spent on admin could be contributed to the PS plan. In a DB plan the sponsor never knows if the plan will be over or underfunded when he/she retires because of the volitility of interest rates and investment returns. If the plan is over funded there is a problem of how to extract the surplus without paying penalty and income taxes. At a minimum the employer will take a haircut of at least 25-35% of the surplus. If the plan is underfunded then the employer must either make additional contributions or take a lower benefit than expected. At your age you could establish a SEP plan which has the lowest cost of all plans because the contributions are held in an IRA so there will be only a minimal admin charge from the custodian. Contributions can be as much as 40K. I am assuming that you do not have any employees if you establish a SEP.

[Guest firstq]

Guys - appreciate your insight. I looked at the paperwork this actuary provided to me and I am not mistaken - the number are in the range I have indicated.

He is an Actuarial Consultant himself - and we were not talking about 412(i) - which is the insurance one (if I am not mistaken) -

Having said this, I will confirm as to the details. The person's credential's check out ok (atleast on the surface) - he is an american express advisor and has an established practice here locally in Phoenix and I wen to him through a referral.

Having said that, I will check with atleast another actuary before starting the process - I really am looking to put away more than the PS Keogh limits (a little bit more) - If the number he is telling me is correct, I would not mind the expenses for the few years I may be in the plan - the end would be to terminate the DB when the money would be rolled over into IRA (that is what I was lead to believe - as rolling to IRA is not possible in a 412(i) plan - leads me to believe that the plan he was talking about was nothing to do with insurance) - also 412(i) deos not require actuarial certification (if I am not mistaken) - all of these indicate that 412(i) was not the option on the table in our discussions - I will confirm.

Again, bunch of thanks to all who provided valuable feedback.

[AndyH]

You are dealing with a life insurance salesman, not an actuary.

A plan doesn't have to be a 412(i) plan to be loaded with life insurance. Beware, the numbers do not work. Sounds like you need to get a stronger brand of shark repellant.

[Guest firstq]

Andy - I will be vigilent, have already started checking around - will post what other actuaries say.

Thanks

[Guest Keith N]

The fact that he describes himself as an "Actuarial Consultant" doesn't mean he is an actuary. Also, the fact that he "is an american express advisor" most likely means that he is paid to sell product. That is how american express makes money. (Not that there is anything wrong with that.)

When you are dealing with an actuary who is paid to sell product, you need to ask a lot of questions relating to possible confilicts of interest. This is why most actuaries are independent and do not sell products.

[MGB]

I completely agree with the prior postings that 80k is too high, it should be much less than 40k. Either they are going well beyond the IRS guidance and law (in which case you are opening yourself up to major headaches with the government and loss of a lot more money through fines and taxes) or else the plan is being heavily invested in insurance (or annuities, or whatever product produces high commissions and fees). Most plans with insurance in them are not 412(i), the insurance is just another investment in a regular qualified plan.

If the person had credentials from any of the actuarial organizations (Society of Actuaries, Conference of Consulting Actuaries, American Academy of Actuaries, American Society of Pension Actuaries), they would be listed in the online directory of actuarial memberships. There is no employee of American Express in Arizona listed in the directory. Only persons that are members of these organizations are subject to the professional codes of conduct. Using a non-member subjects you to the risk that they can say anything they want and not be subject to discipline.

[Guest firstq]

Okay - the guy is an actuary himself - for the last 20 years. American express financial advisors are not employees of AMEX, they are field reps that work for commission - so they will never be listed as AMEX employees anywhere.

There is no insurance at all - no products to buy, strictly on a fee basis. The money will be 100% self directed.

After the end of DB - whenver it happens, the money will be able to moved into an IRA.

Anything else to watch out for? The plan is not a 412, he mentioned 409/410 - not sure.

The numbers are based on spousal income factors as well...

Here is the breakdown:

around 50K for the DB

around 22k for the two of us in the 401K [11k each] (non integrated)

Thanks

[AndyH]

Two of you in the DB? 25K and 25K?

Now we're getting somewhere.

[MGB]

AndyH,

The only way the DB could be split 25-25 is if the spouse also will be earning 160k.

It is probably more likely about 40/10 split with the spouse having substantially less income.

firstq,

Were you always planning on having the spouse take large income in this business? Note that in order for the spouse to have earnings that can be used to generate pension contributions, the spouse's earnings will probably have to be substantial. Every bit of earnings that is switched from you to the spouse is going to generate another 15.3% tax for SS. This should definitely be factored into any analysis.

Also, make sure that neither you nor the spouse are putting money into another 401(k) or 403(B) plan of another employer. If the spouse is working elsewhere and is contributing to a 401(k), then the total between that one and this one can't exceed 11k (12k in 2003). This is an individual taxpayer limit, not a plan limit.

[david rigby]

I too am very skeptical. Even if there are two high earning participants in this plan, it is pretty hard to get a 80K contribution at that age. Certainly sounds like the contribution is loaded up with commissions.

I am also skeptical that this person is an actuary. Go here (click on "Search the Directory") if you want to check the credentials of anyone claiming to be an actuary. Those of us who are listed there do not smile on others claiming to be.

[Guest firstq]

I searched the directory, and here are the credentials. I just am not sure if I should list the personal name here on the board.

<>

Designations

EA 197X

MAAA 197X

MSPA 198X

As far as the comissions go, there are no products to buy , so not sure how and where the comission would come into play?

I appreciate the concerns, he may be pushing the envelope, but there are no comissions beyond the plan setup and ongoing yearly admin fees - and from what I have found to be the street price, his fee schedule is in the middle.

The spouse's earning is only to the extent to max out her 401K max (I think around 12K) - I will verify.

[david rigby]

If you are interested in finding another actuary for a second opinion, you can use the Directory or the Pension Assistance List.

[mwyatt]

I've been kicking this whole idea around today, and I think that this rush to a DB plan at such an early age may not be in your best interests, especially after the repeal of 415(e). Prior to the repeal, using a max DC plan early on would work against the amount you could ultimately contribute to a DB plan; won't bore you with the calcs, but the "old timers" out there are probably familiar with the mathematics of the 1.0 rule. Now, however, there is no penalty involved in making the 40k contribution to a DC plan earlier in your career.

DB plans are a pretty simple sell when you can demonstrate that you can trump a DC contribution by a factor of 2 or 3 times the max under a DC plan. You've outlined an 80k combined contribution between your spouse and yourself including a "uni401k" double deferral of 22,000, leaving you with approximately 58k in DB deduction between you and your wife. It might be a little shortsighted to chase that DB deduction right now in the scheme of things, assuming that you continue to sponsor your own plans down the road. Let's say you stick with the DC deduction of 25% of 250,000 (what you have to play with between you and your spouse's income - keep in mind the comments about FICA taxes in pushing income to your spouse - a very real factor that you should factor in). So you put a combined contribution of 62,500 into a DC plan for the next few years. When you are 45 or so, you now have 12 years of the DC contributions sitting in your account with no adverse consequences to the amount you can fund in a DB plan, and your DB plan can now see contributions that have a serious magnitude over what you could do in the DC plan, since 415(e)'s repeal allows you to ignore these prior contributions. Remember, even if you set up this DB plan now, you are going to be taking out serious accruals from the DB 415 limit in the future, since prior DB plans DO reduce the dollar limit down the road.

Just a thought, and it's late at night on the East Coast, but you might want to contemplate the big picture before acting. I really don't think in the long run that setting up a DB plan right now will maximize the amount that you could accumulate at retirement.

[Guest firstq]

Max, as the business conditions are such that their is no surity as to the length of the operations and the amount of money either - so worst case scneraio --> few years into the plan - then terminate and roll over to IRA. I am not anticipating this to last for the next 12 years - who knows...

Thanks

[mbozek]

If you are not intending to continue the plan for 12 years you should not be setting up a DB plan because of the additonal costs to start up the plan and the additional annual expenses for maintaining/ terminating the DB plan will eat up a substantial portion of the contributions that you make to the plan. If you earn 200 k and pay your spouse 50 k your maximum contributions to a 401(k)/ps plan will be 40K(you) + 22.5k (spouse) to the ps plan + 11K each to a 401(k) plan for a max contribution 84.5K in 2002. After deduction of about $3400 in fica tax contributions the net amount of the 401(k)/ps contribution will be about 81 k. The max 401(k) contribution will increase to 12k each in 2003 for a max contribution of 86.5k. The max contribution to the PS plan is limited to 25% of comp because that is the maximum amt that can be deducted under the IRC. The expenses of setting up a 401(k)/ps plan are minimal compared to a DB plan and it can be terminated at any time and the aco**** balances can be rolled over to an IRA or the plan can be frozen and replaced with a DB plan.

[Guest firstq]

mbozek: makes sense, appreciate your analysis.

40K + 22.5K + 22K = 84.5K

2 quick questions:

A. if the amount you can put into PS is 25% then how come for spousal income of 50K allows to put away 22.5K?

B. How much is the typical street cost of setting up & annual admin fees for the PS sharing + 401K plans?

The numbers I am playing with this guy is around 7K total for the 3 years (setup + annual fees). The spousal earning in this plan is only 12K - so mostly goes to 401K with no taxes. This way no $3400 annual penalty. So on the face, I will be loosing more every year in the scenario you are proposing.

In your plan - say I stay three years in the PS + 401K plan. Setup and annual fee (lets be conservative = $750 average for each year) would mean $750*3 = $2250, 3 years of FICA @ $3400 yearly = $10200, so for 3 years we are already way past the 7K it would cost me if I go with his (DB) plan.

Am I missing something basic here?

Thanks again.

[Guest mel222]

This is interesting. I am also in Phoenix (and in IT) and have been considering a DB plan. I am 40 and have decided not to establish a DB plan this year.

I have good income and 02 and 03, but 04 and beyond is completely unknown. I am uncertain about the contributions I would be making starting in 04.

The primary reason I will not establish the DB this year is the costs to establish, maintain and terminate the plan. The tax savings the the DB plan offers is only a tax deferral (at maybe a lower rate). The costs are a real expense.

The gentleman who introduced me to the DB plans seemed to be pushing the edge. His suggestion was to have all the income flow into my S-Corp. Here I would pay myself, my spouse and even family members a nominal salary (something like $1000/year).

His plan was that the DB for the family members would be a plan with a 3 year vesting period. The family members would not be working(ie Terminated) before their account vested. The contributions made for these terminated employees would flow back to me and be added directly to my DB plan.

He stated that the defined benefit had no relationship to salary. So you can pay an employee $1000/year and yet contribute 10, 20, even 30 thousand dollars to each employee's plan. This gets around the FICA problem mentioned earlier.

This whole plan appears to be pushing the envelope pretty hard.

Parts of this plan are attractive. For me to contribute the max $40,000 (deductible) to my keogh, I must pay myself atleast $200,000. This will require my paying the top end medicare tax of 2.6% for the last $110,000 or so.

With this guy's plan, I would only pay myself a $40,000 salary, put $68,000 in the DB and dividend the remainder back to myself.

Comments?

[mwyatt]

Math on PS contribution:

IRC 404 limits you to 25% total eligible contribution NOT including 401(k) deferrals (all effective in 2002). IRC 415 limits individual participant (NOT employer) to lesser of 40k and 100% of compensation. Actually MBOZEK his 401k deferral does count against the 40k 415 limit, but this can actually wash out as this amount can be allocated to spouse instead.

So:

Total eligible salary equals 250,000 providing 62,500 in 404 eligible deduction PLUS 401k deferrals.

You defer 11,000 on 200,000 compensation, get 29,000 PS (up to 415 limit) allocation for a total of 40,000.

Your spouse gets balance of 62,500 -29,000 = 33,500 plus 6,500 deferral (can't exceed lesser of 40,000 and 100% of 50,000);

hence you both get 80,000 combined for year on 250,000 compensation without having commitment of DB plan (plus without screwing up ability in future to get 100k DB deductions).

[Ron Snyder]

As an actuary who formerly practiced in Phoenix, I have a couple of comments:

1. The person who noted that a DB plan was premature was correct. You can start funding the max on a DC plan until age 45 and switch to a DB plan at that age and obtain a much greater tax benefit and larger retirement accumulation.

2. Aggressive Phoenix actuaries (and I can name them) caused the IRS national "actuarial audit project" several years ago. A certain actuary was funding for future COLAs in excess of the current IRC 415 dollar limit without disclosing such disagreement with the IRS on an attachment to the Schedule B.

3. Ken Klingler at Watson Wyatt and Bob Tellier at Scott Tellier Co. are highly reputable Phoenix actuaries. Some Phoenix actuaries are to be avoided.

4. DB plans for self-employed are flexible enough to permit skipping funding in years of loss with appropriate and timely planning. Note that no deduction is permitted even if required under IRC 412 in a loss year, so working closely with an actuary is a necessity.

[Blinky the 3-eyed Fish]

Vebaguru, as a Phoenix actuary I must point out that not only are some Phoenix actuaries to be avoided, but some Salt Lake City actuaries are to be avoided as well. Come to think of it, some LA, NY, Miami, Houston, etc. actuaries are also to be avoided.

There are good and bad in all businesses. With actuaries it is easier to have a client choose you if you are able to promise them a higher deduction. Thus, there is that tendency for some to push the envelope.

So you pick one of those actuaries, then if you try and terminate the plan, but are unable to payout the plan's assets because they are too high, or if the IRS audits your plan and disallows the deduction due to bad actuarial practices, you will wish you had made a wiser actuarial choice.

By the way, firstq, you have already posted enough information to figure out who the actuary is you are consulting with currently.

[mwyatt]

I'm glad someone out there remembered the pain that the Small Plan Audit program caused in the 80's. We had a couple of clients sucked into the maelstrom of (IMHO) abusive strategems by what appeared to be predominately West Coast actuaries. We had a client dragged in who was "abusing" the system by funding a 5 life plan to the astronomical tune of $35,000 a year total contribution. Let's all remember not be pigs!

[Guest firstq]

Blinky - so is he to be avoided?

[david rigby]

I don't know if Blinky will answer that question. I would not.

This message board is not the place to "trash" other professionals, in any discipline, even if sometimes they might deserve it. None of us are perfect. However, the point has been made very strongly by several contributors that the original suggested plan contribution does not fit with the suggested plan design. This does not mean that the result is not acceptable under the tax laws for determining funding and deductions.

But, proceed at your own risk. Or at the risk of overpaying. A lot.

[mwyatt]

Being on the East Coast without any personal knowledge (which some of our other contributors clearly have) of the personalities in question, one can only comment on Firstq's inquiry as to the logic of the proposed plan of action. I think that the best thing to keep in mind is not only the beginning, but also the ending of any retirement plan.

We've just finished off resolving a few plans set up pre TEFRA without paying out the excess to various government entities, thanks to enhanced EGTRRA 415 limits and (unfortunately) a rather precipitous drop in asset values. Plans set up for extremely young participants are fraught with peril (may work with historically low 30-year treasury rates at the moment, but may face overfunded status with changes to the economy and/or the 417 benchmark rate). Remember, in a DB plan you are funding for a specific amount that you are allowed to take out at "retirement". I think that we can safely assume that these structures only make sense with the benefit pegged to the maximum amount allowed under the law. But the law is a slippery slope, which can be contracted at any time.

Firstq, best off to investigate the possibilities at your age of the enhanced DC limits. Check back in 10 years when the contribution under a DB plan using conservative assumptions clearly outshines what you can add under a DC plan.

[four01kman]

I'm with MWayatt on the best approach with the most reasonable dollars going into the plan. I have a real concern with the permanancy requirement for a short-term db plan. Not something I have seen the IRS address in recent years (it seems they have had other fish to fry), but years ago this was something they really looked at on plan termination.

[AndyH]

Well, this plague is spreading to the east coast. I took a call yesterday from a broker with some ethics. He said an accountant for a client of his who is age 46 and had a spouse of the same age had recommended a 412(i) plan with annual contributions for the two of them of about $300,000. He asked my view. I said it is bogus. It reminded me of this situation.

The proposal as it was explained to me was for this program to last 5 years, at which time some type of "purchase" of the contract would be made. Sounds like some type of springing cash value scam. Apparently the proposal projects 9% dividends, which of course are backloaded, so even if true it would take many years just to recoup the dollars contributed.

And in 5 years the 415 limits would be no more than 1/2 of the dollars contributed, so I can't see how a termination would make sense. I told the broker that whoever sells this should be sued in 5 years when the reality of the situation becomes apparent.

[Guest death and taxes]

Wait a minute!!! You talked to a broker with ethics?!?!?

[david rigby]

He said "some ethics".

[mbozek]

There are some ins co that pay a commission of 100% of the first yrs premiums. I doubt that any ins co would project 9% dividends in this investment environment when annuity rates are between 4-5%. Also Ins co cannot guarantee dividends beyond the current year. Springing cash values are also prohibited but this an audit risk. The real question is what would be the $ benefit to the owners when the plan is terminated, the assets are paid out and taxes are due. One tax issue to consider is the tax benefit rule- A taxpayer who recieves a tax benefit, e.g., deductible contributions, may be required to recapture a portion of the deductions as taxable income in the year the plan is terminated under IRC 111(a) if there is any "recovery" of the amount deducted in any prior year.Although this rule appears limited to a return of plan assets to the employer, the client should consult with a tax advisor to determine the potential tax risk of entering into this transaction.

[AndyH]

Well, I was told by a second person who saw the proposal that the projected dividends in the proposal were in fact 9%, and that at 9% the cash surrender value of the contract would not equal the dollars contributed until 15 years had elapsed. So that must be the trick. Investment income is consumed by "expenses", ala a life insurance policy.

[mbozek]

I dont think any insurer can project 9% return under NAIC guidelines without a lot of caveats and in any event it 9% is not guaranteed. I dont know of any insurer that could produce a 9% return for 15 consecutive years. Caveat emptor.

[Guest firstq]

Guys - I am back - and would like to request sort of final thoughts:

As suggested in this thread, not going with the actuary, what would be the best setup for maximizing the retirements contributions?

Can I put away 40K in SEP-IRA for myself and then draw 12K each for myself and spouse as salaries and put it away in our 401K?