Self-employed? Perhaps it is best to recharge your retirement

Read this if you are interested in a $ 230,000 tax deduction.



If you’re older, you can put $ 7,000 into a tax-protected IRA. You can earn $ 26,000 with a 401 (k) grace period. Or you could use a completely different vehicle to get the contribution deep into the six-figure range.

A “performance-oriented” retirement for the self-employed is up for discussion here. It’s complicated. There are fees associated. But it can save a bundle for high-paying self-employed people like doctors and lawyers.

This is how the game is usually played. In a career – around the age of 50 – you open a retirement plan that provides a certain annual payment from the young age of 62. To pay for this service, you need to amass a large sum.

So much to do in such a short time! At least that’s what you tell the Internal Revenue Service, with the assistance of some employed actuaries. They inform you that all you have to do is scoop the money in to make your target payout happen.

This is great news because you get a tax deduction for what comes in. Including the pay deferral that ordinary people can afford and a profit-sharing contribution thrown on the ice as sprinkles, you might get a tax deduction of $ 230,000. Ideally, the deduction will take you to a lower tax bracket and / or make you eligible for that temporary 20% pass-through deduction that Trump developed.

The crowded retirement makes sense for young professionals who are earning a lot more than they need to live. It works for people who are their own bosses and have few, or preferably no, business employees: if you’ve hired help, you can’t set up a lavish pension for yourself without involving them on the same terms.

Joseph Roberts, an asset manager at Rockefeller Capital Management, says he has recommended defined benefit plans to some of his clients. The operative word is “some”. There are significant drawbacks.

First, there are these actuarial fees. Next, there is little flexibility: once the plan is in place, you have to keep funding it, good times or bad come. And then there is the risk that if you withdraw the money in retirement you will be in a higher tax bracket, which will cause the deferral to backfire. For some taxpayers, Roberts warns, “The juice isn’t worth the pressure.”

For an optimistic picture, let’s turn to Dedicated DB, which has created 4,500 of these plans. Dedicated is part of Ascensus, a company that specializes in tax-privileged investment plans such as retirement plans, 529 college savings accounts, and health savings accounts.

Dedicated DB describes a hypothetical client. Ellen Sample is a 50-year-old single gynecologist with an income in the mid six-figure range. She creates a plan that pays $ 230,000 annually (the maximum allowed by tax law) from the age of 62.

To accomplish this goal, she makes $ 187,800 a year and expects the account to grow to $ 2.8 million in retirement. In addition to the fixed payout, the plan has a 401 (k) feature that allows the doctor to defer $ 26,000 of their salary along with an employer contribution of $ 17,100. Of course, in this tax dance, employer and employee are the same person.

At some point, maybe just as she turns 62, Dr. S finish the plan and turn the fortune into a simple old IRA. It’s like a giant corporation exiting a defined benefit plan, only that the giant corporation is probably trying to stiffen the workers, but here the worker stiffens the tax collector.

Fees: At Dedicated DB, the doctor would pay $ 1,450 to get the plan up and running, $ 2,500 a year to keep it going, and $ 1,500-2,500 to cancel. The menu is very similar at Charles Schwab & Co., another provider of performance-oriented small businesses.

How does this cost compare to the tax benefit? The tax deferral arithmetic is very confusing. To cut through the nebula, start with this simple axiom:

For a taxpayer whose bracket does not change, a deferment is equivalent to an exemption from tax on investment gains.

To see why this is so, consider the taxpayer T in the 40% class. T has to set aside a salary of $ 10,000. With a retirement home, the money is tax-free until it has tripled. That brings $ 30,000 to the account, which is taxed on the way out and T provides $ 18,000 for retirement.

Without shelter, the salary instantly drops to $ 6,000. Without taxing investment gains, that $ 6,000 would triple to the same $ 18,000. But of course T owes taxes on dividends and capital gains, and so the $ 6,000 will grow to a lesser amount. So the value of an IRA or 401 (k) is the investment tax averted.

How burdensome are these investment taxes? A full-market stock index fund offers a 1.4% return, and a reasonable estimate for the tax rate of T on dividends is 25%. (Most dividends would have a base rate of 15% or 20% plus state income tax and a surcharge of 3.8% for some individuals.) So your retirement plan could save you 0.35% of the dividend assets annually in taxation.

That said, once you have $ 1 million in the account, you might be saving $ 3,500 a year. It doesn’t look bad paying actuaries $ 2,500 a year to keep the IRS off your back.

What about capital gains taxes? It takes some guesswork, and I think the best guess for the capital gains tax rate is 0%. People who don’t have to redeem their shares to cover rent, and whom we’re talking about here, have four ways to lower the tax on appreciation: Harvest losses, philanthropy, Family mixes and rise at death.

So far in this analysis we are assuming that your tax bracket for ordinary income, a category that includes salaries and retirement distributions, will not change. Now think about what happens if this is the case. If you want your bracket to be lower in retirement, the benefit of tax deferral increases. If your brace is climbing, shifting is likely a bad idea.

Perhaps you live in a high-tax country and plan to retire in Florida. Then a big ticket retirement might make sense, says Rockefeller’s Joe Roberts. Are you planning to stay here? Think again. Legislators in New York, California and Illinois want to raise tax rates.

I have no idea what will become of federal tax law by the time you retire. The interest rate hikes for both ordinary income and capital gains threatened by the Democrats would tend to make pension plans more attractive. On the other hand, what can stop Congress from rediscovering the 1987-1995 surcharge of 15% on “excessive” pension payments?

If you can base your defined benefit plan on $ 1 million and keep it up for a decade, you will likely be one step ahead. If you can’t, consider a less sophisticated control system: the Solo 401 (k). Discount brokers incur no setup or annual fees for a Solo 401 (k). It can protect $ 63,500 a year. It is explained Here.