Help Needed. Deductibility question from a 'civilian'.

[robbie]

Hi,

I'm neither a lawyer, an accountant, nor an actuary...so please excuse me if I mangle the terminology. I am 71 and my wife is 73 and we are considering opening a "solo-DB" plan for the next three to five years that I plan to continue working. One of my goals is to alleviate the tax impact of being forced to start receiving rather large MRD's this year. The value of the DB depends on the deductions I could receive. I have several questions after having 'lurked' on this board the last few days.

1)Is it true that an owner-only plan is considered to have no employees, so is not an ERISA plan and not covered by the PBGC? If so does that fact influence the answer to the next questions?

2) Can I base the defined benefit on the average of the 3 highest years Sch C earnings even though my earnings this year are considerably lower...and probably will continue to be?

3) Will the deductibility of the advertised large contributions be limited to my current Sch C earnings? I have seen statements to that effect, but others that extend the deductible limits to the "unfunded current liability" or to the "accrued liability". Would those likely be larger than my now reduced Sch C earnings, and which prevails.

Any help will be appreciated. Thanks.

[Guest Doug Goelz]

1. True

2. Yes

3. As a sole-proprietor, your tax deduction for a given year is limited to that year's Schedule C income (reduced by 1/2 of your self-employment tax deduction). You should just design your plan to "back into" the formula needed to completely use up your available deduction for the first year. You can always amend it in the future if you need a higher deduction.

[robbie]

Doug,

Thanks for the quick reply...though it isn't what I was hoping for.

Would this work? Set up the plan as you describe to use up the max deduction available based on my present rate of earnings. Then set up a no-cost solo 401(k) at Fidelity. Can my wife and I then make deductible elective deferrals of $32000 (including catchups) but no profit sharing contributions...in addition to the max DB contribution?

[Guest Doug Goelz]

If your DB deduction is such that you would have no Earned Income for the year, then you would have no income to support the 401(k) deduction. Also, if your wife received pay from you, wouldn't that be entered on your Schedule C and reduce your self-employment income further?

[robbie]

Doug,

If I understand it right, (a big if!<g>), the schedule C would still show my earnings on the bottom line, which is then transposed to page one of the 1040 as "earnings from business." Then, lower down on the page, under "adjustments to income", would be my DB deduction. Therefore I would still have earned income on which to base elective deferrals.

Is this cockeyed???

As for the second point, yes the pay to my wife would reduce my earned income but hers would be all wiped out by her elective deferral.

As I think about this I might prefer a smaller DB deduction which seems fixed and immutable and supplement that with the elective deferrals which by definition are elective, giving me more flexibility.

I realize I am a rank amateur mucking around in these arcane matters and I really appreciate your taking the time to help me clarify my ideas.

Thanks,

Robbie

[mbozek]

the owner of more than 5% of the employer is required to commence MRDs from qualified plans after 70 1/2. So you will be required to receive distributions form your plans this year unless vesting is deferred in the DB plan. You will be required to commence mrds in any 401k deferrals made this year. Also the max DB benefits are phased in 10% per year so that in yr 1 the max benefit accrual is 16.5k year, 2 33, etc. Dont know how you fund for this benefit if you are past Normal retirement age at inception of the plan. Before you start up this plan you need to talk to an actuary and accountant.

[JAY21]

mbozek, couldn't he use a Normal Retirement Def'n equal to say the later of (a) age 65 or (b) 5 Years of participation which effectively pushes his retirement age to age 76 ? I agree that doesn't get him out of 70.5 distribution issues though on vested benefits, but at least he could fund the bucket (plan) with a small hole in the bucket (70.5 distributions). Also I think his 415 limit gets an actuarial increase beyond age 65 so it would be larger than the 16.5k per year.

I take it the big disappointment is not being able to deduct more than the Schedule C income (minus 1/2 of S.E. Tax) to wipe out the RMD income.

Robbie, it's a good thing you don't get into this business full-time or you might put the rest of us out of the business with your quick study.

[Guest Doug Goelz]

Robbie, I used the term Earned Income in my earlier response. This is a term used in the regulations to identify your adjusted self-employment income that would be used by the plan for various things such as determining your deduction limits.

The way the IRS defines Earned Income would result in you having nothing to support a 401k deferral, if your DB deduction was so large as to result in $0 in Earned Income. The calculation of Earned Income is somewhat of a lengthy subject to discuss fully.

You are correct about the DB deduction for yourself being claimed on your 1040 tax return (which comes after your net Schedule C income determination). But things don't quite work this way when determining what your Earned Income is for plan purposes.

For Earned Income, you take the Schedule C income, subtract 1/2 of the Self-Employment tax deduction, and then subtract your DB deduction. This is a quick comment, but just know that because of the way this works, you could have no Earned Income to support your 401k deferral.

As others have pointed out, there are numerous issues you should explore before moving forward with any plan. Have you been discussing this with a professional at all? You do sound like you have a nice grasp of some of the issues though!

[robbie]

Wow, You guys are really helpful and smart.

mbozek, thanks for the clear and concise tutorial on the mrd's, and especially for clarifying how accrued benefits work. I didn't understand that at all.

jay21, thanks for the compliment. From lurking on the board I found myself actually quite intellectually fascinated by the problems you guys discuss and the logical quality of the thinking. You're right about my disappointment that I can't find a way to offset other than schedule C income. Even if my 415 limit is actuarially adjusted above the 16.5K that still doesn't solve the deductibility limit, am I right about that?

Doug, you're really a good teacher. Now I understand more clearly how the term 'earned income' is being used differently for the plan purposes.

Everybody...what is a cash balance plan and would that offer any better solution for me...or any other suggestions?

Thanks again for all your help. I will be meeting with an actuary and a pension lawyer and financial planner, but I find that doing my homework like this, and being as fully informed as I can be, helps me to know what questions to ask, and to better evaluate the opinions rendered. So, thanks again.

[SoCalActuary]

A cash balance plan is a defined benefit plan that uses a hybrid formula to define the benefit you receive. Generally, a lump sum account is determined, and the annuity benefit becomes the actuarial equivalent of the lump sum.

For example, a lump sum account of $50,000 is derived as 25% of $200,000 of pay. In the following year, the $50,000 is credited with a fixed amount of interest, say 5%.

The new lump sum value is $52,500 on the second anniversary. If the participant made $20,000 in pay for year two, then 25% of 20,000 = $5,000. This would be added to the 52,500, giving a new lump sum value of $57,500. At each anniversary, you would convert the lump sum value into an equivalent annuity value, using the conversion rates in the plan document. Those rates could even vary from year to year as interest rates change.

With this very simplified explanation, I like cash balance plans because they provide a more stable benefit value from year to year, especially when partnerships sponsor them. They work well when two or more owners want to divide the funds in proportion to some earnings formula between themselves. In addition, they can provide very high benefits for people over age 40. Properly designed, they are less subject to surprises of pay changes or interest rates than most db plans.

With that said, you should only do cash balance plans with people who have the training and experience to do them.

[FAPInJax]

One thing that was not mentioned was that the DB plan could have a cliff vesting schedule. This would delay the impact of the minimum distributions (at least temporarily).

[stephen]

Interesting concept to encourage a solo-DB sponsor to use a cliff (five year) vesting schedule to delay MRDs. It would allow them to accumulate five years of contributions before required MRDs would begin.

[Blinky the 3-eyed Fish]

Ah, but could you use a 5-year cliff vesting schedule? The plan would certainly be top heavy, so a 3-year cliff would be required. I don't see a way around this even though there are only keys in the plan.

[AndyH]

Hey Robbie,

What you are contemplating is "high maintenance". You have a lot ot traps to be weary of. One issue is called "permanency", the concept that the plan is intended to be permanent, not a quick and temporary tax shelter. I tell prospective clients they should commit to five years. Three might be enough, but .....

Also, if you want this to last 3 years, you need to make sure that you don't have a required contribution in year 4, and also that you don't have a required contribution in year 3 that exceeds your Schedule C net income.

You need to hire somebody that knows what they're doing, including all of the issues discussed above, and will be very attentive and hands-on. That won't be easy to find and it won't come cheap. You could not hire many of the people that have responded to your question if you wanted to. Most work on bigger fish.

One is a bigger fish.

[Effen]

Blinky,

Top Heavy mins only apply to Non Key's. The owner would be Key and therefore would not have to receive the mins.

[Blinky the 3-eyed Fish]

Effen, you missed the point of what I was saying. I was not espousing that a minimum benefit is required; not even remotely was I saying that. Please reread my post.

[Effen]

I was using "Top Heavy mins" to mean both benefits and vesting. That said, I just gave a quick read to 1.416 and didn't find anywhere that the top heavy vesting can only be applied to Non-Keys.

Since I have a plan where the attorney said this was "ok", I will need to dig a little deeper. I assume you are stating that Top Heavy vesting would apply to everyone?

[Blinky the 3-eyed Fish]

I assume you are stating that Top Heavy vesting would apply to everyone?

I would put it more like this. I am stating that I know of nothing that allows you to have a non-TH vesting schedule in a TH plan, even if the plan covers only keys, or anything that allows you to apply the non-TH vesting schedule to only keys when the plan is TH.

[stephen]

As usual, I agree with Blinky...

[robbie]

I'm back...Thanks everyone for all the helpful input.

SoCalActuary...that's the clearest explanation anyone has given me of the "cash-balance" plan. It doesn't seem appropriate for me unless...wishful thinking here...it yields deductions in excess of my schedule C...???

As far as vesting I was going to only ask for a 3 yr cliff anyway.

AndyH..that bears on the issue of Permanency...Couldn't I make a plausible, reasonable, and true case that because of the bloodbath since 2000, I have had to catch up a lot, but since I am already 71, working for 3 more years is not an unduly short proposal.

Also, AndyH...I take your last point seriously. There is obviously a cost-benefit analysis I have to do before getting too fancy. And I certainly appreciate the high-power information I'm getting from folks like you all who I couldn't afford to engage privately!

[Larry M]

Robbie,

the high powered information you are getting is a joy to give from most of us.

It reminds me, though, of the times my mother was asked for the recipes for her prized apple strudel. She gave it, readily, to whom ever asked. But, somehow, the results of the others' baking was never as good as hers. There is something about experience which allows you to adjust for a change in temperature or the feel of the mix or the size of the bits of the nuts.

So, too, with defined benefit plans which are designed to be specific to an individual's desires.

So, please, please, be aware there are many items which we have not discussed which could have a dramatic effect upon your plan. For example, you mention you have minimum distributions starting. From what kind of plan did these derive? Was this a defined benefit plan from a company you owned? If so, your new plan's benefit may be restricted.

Further, no matter how much information you receive from us, in order to adopt and maintain a defined benefit plan, you will need to hire an actuary, you will need to have a plan document and, as a result, you will be incurring some modest expenses, annually to design, implement and maintain the plan. There is no way around this - especially if you want to squeeze as much out of your earnings as you appear to want.

There is another "further", Congress has a tendency to "improve" [most of us would choose the word "complicate"] pension plans on an extremely frequent schedule. Each such "improvement" will involve costs to your plan and may involve a complete change in the course of your planning.

So, here is some more advice:

Sit down for an hour or so with a local consulting actuary (get a referral from a friend or an attorney steeped in ERISA) and, if he or she charges for the hour, it will be worth every penny. [Many of us will give you the hour as a "freebie" or absorb it in the fees for our continuing service to you.]

[robbie]

Larry,

Thanks for the sound advice..I definitely am going to consult with an actuary and an ERISA attorney. I know this isn't a do-it-yourself project. But the information on this board has at least equipped me with good questions to ask and more ability to evaluate what I hear. I am a physician and know well that patients often get conflicting recommendations from different, well trained and well meaning, doctors. There's usually more than one reasonable approach to any given situation and the patient's values need to be factored into the risk-benefit analysis in the decision process. So, I wouldn't take any one doctor's opinion as 'gospel'. Similarly, here too I want to be 'an informed consumer' with at least enough understanding of the situation to participate meaningfully in evaluating my choices.

So, I thank you all again.

Bottom line, since I now know that a self-employed person's contributions are only deductible to the extent of earned income, and that there are adverse consequences possible from having accumulated non-deductible contributions, combined with the significantly greater expenses associated with a DB, I am leaning more to the idea of a 'solo 401(k)'. Any thoughts?

Robbie

[Larry M]

Robbie,

Two thoughts:

one - spend some one on one time with the actuary and ERISA attorney, and

two - the 401(k) plan in all probability will produce a smaller contribution (limit is 25% of net earned income) and immediate vesting of your deferrals (which, although they are not counted towards the 25% limit, do mean the minimum distribution requirement is not deferred), and

three - as you can see, the simple becomes more complex.

[This message illustrates an old joke - there are three kinds of actuaries - those who can count and those who can not.]

By the way, in my earlier response, I was going to use the example of the individual who is not a doctor, reads Grey's Anotomy, watches ER, reads the "Your Health" section of the Sunday paper, diagnoses his illness and then tries to perform an appendectomy on himself... but I liked my mother's strudel better. It was in better taste...

[robbie]

Larry,

Reminds me of the one about the rabbi, the priest and the minister...except I forgot the punch-line! I'm sure I would prefer your mother's strudel also.

I do know about the MRD issue which was one of the advantages of having a DB with cliff vesting. The catch 22 is I might need the MRD's to have enough cash flow to make the big contributions! Anyway, I am meeting next week with the actuary and a financial planner who works with him to play out the different scenarios..and we're all keeping in communication with thw ERISA attorney, so some decision is imminent.

I'm sure you're all waiting with bated breath to hear the outcome <g>.

Robbie

[AndyH]

Beware the actuary who works with the financial planner.

Only 1/2 kidding. If you hear "412(i)" then come back and visit us.

[robbie]

Andy,

Thanks for the heads-up.

I don't think they're in the 412(i) business, but I'll be alert for this.

Robbie