Starting a one person pension plan

by Tony Novak, MBA, MT, OnlineAdviser at Freedom Benefits, last updated on 11/30/2011

High income self-employed individuals can save tens of thousands of dollars on income taxes each year by setting up their own pension plan. These plans allow taxes to be avoided on hundreds of thousands of dollars of income- up to about $4 million over a working career - by transferring some pre-tax income into a retirement plan account. In contrast, traditional retirement plans like 401(k), profit sharing and Keogh plans typically limit the tax deduction to only about $42,000 per year. A maximum tax-deductible pension plan contribution can be many times larger than the maximum 401(k) plan allowance, often reaching hundreds of thousands of dollars if desired.

"A maximum tax-deductible pension plan contribution can be many times larger than the maximum 401(k) plan allowance... These plans are especially popular with realtors, general contractors, physicians, attorneys and accountants."

While pension plans are available to any business, they are especially popular with one person businesses. This is simply because 100% of the plan' s cost goes directly to the business owner' s investment account. These plans are especially popular with realtors, general contractors, physicians, attorneys and accountants. Recently a number of other health care professionals including physical therapists, optical professionals and nurse anesthetists and real estate related occupations including architects and remodelers) have used these plans as their incomes grow in the current economy.

Most small business pension plans are "insured plans", meaning that they are exempt from many of the more difficult requirements of the IRS and Department of Labor. These are also known as "412(i)" plans named after thee section of the Internal Revenue Code that permits the more liberal management. I prefer the more descriptive name "Target Benefit Annuity Plans" that more accurately summarizes the plans. These pension plans are easy to start and operate when the business owner has a clear understanding of the options available. When the options are selected, the plan can be started within one business day. The plan paperwork must be completed before the end of the tax year. The first year' s contribution must be made by the due date of the business tax return.

Step 1. Estimate the amount of the intended contribution.

Planning often starts with estimating the amount of the current year tax-deductible contribution that you would like to make. This might seem like "backwards planning", and in fact it is. But the amount of the immediate tax deduction available is often the most important factor to the individual planning the pension. The amount should be more than $50,000 to make this approach worthwhile, in comparison to other options (like 401(k)s) available for smaller annual contributions.

Step 2. Verify that you can sustain this plan

Your income level should be more than the amount of the contribution, and should be fairly consistent. It helps to provide a 3 year history and 3 year future projection to your adviser. If you were unable to fund he plan in the second year, for example, the IRS might be suspicious of your motives.

Step 3. Determine spousal benefits

A pension plan can provide benefits for your lifetime or the lifetime of you and your spouse. It is up to you. A joint-life plan costs more to fund and therefore generates a larger tax deduction.

Step 4. Determine retirement age

The IRS allows early retirement age at 55. Again, this is up to you. Earlier retirement age increases the plan cost and therefore results in a larger tax deduction.

Step 5. Decide if You Want Insurance

The pension may be insured in the event that you become disabled or dies before retirement age. In either event, insurance allows the plan to continue as originally planned. If you are single or your spouse is financially independent, insurance makes less sense. Insurance increases the plan cost but might not increase the tax-deductible amount because insurance costs are generally not tax-deductible. Insurance may be included inside the pension plan but I generally suggest that it makes more sense to keep insurance out of pension plans. Be aware that insurance included inside a pension plan is more likely to raise the IRS examiner' s suspicion and that the IRS is focusing on this issue as a high priority audit factor.

Step 6. Decide on the Investments

Insured pension plans, as the name implies, are funded with insured investments. This takes away most of the characteristic guesswork and variables in most other types of investment securities. Plans funded with traditional insured products include a built-in commission and usually have no separate administrative charges. If you select no-load investment products, then fees are paid separately. Sometimes, but not always, a better investment is available as a no-load. You should compare both options. This decision is not as difficult as it seems; just focus on your expected net rate of return after all plan expenses are paid. If you select no-load investments, the administrative fees usually total about $650 in the first year and less in future years if the plan remains stable. In any event, we always suggest that you limit total investment expenses to about 1.2% of your account balance.

Step 7. Check the Assumptions

You, as the business owner, are ultimately accountable to the IRS to show that the pension plan is a reasonable business expense. This means ensuring that the assumptions used are realistic. Interest rates and all other assumptions should be within the range permitted by the IRS.

Step 8. Sign the Plan Documents and Open an Account

Assuming the plan was designed with an actual financial product in mind, just make sure that you execute the plan documents and open an investment account with a minimum deposit before the end of the year. Assuming that you serve as the trustee of your own pension plan, you should add an ERISA bond to your commercial insurance package. This typically costs $100 to $300 in the first plan year. Your adviser will be able to provide details and specific cost.

After the pension plan is established and the investment account is funded, the plan is basically self-sufficient until the end of he following year, when all of these factors should be reviewed again.

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Starting a one person pension plan

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