At the age of 40, my friend Al really hit a sweet spot in his medical career. He now puts close to $140,000 per year into his retirement accounts — tax-free.
That might sound impossible given that the contribution limit for a 401(k) plan this year is just $19,500.
But it is doable if you know what you’re doing.
My advice today is only relevant if you’re over 40 and earn a high income of at least a couple hundred thousand dollars as a business owner. If that’s not you, don’t fret. Simply maxing out your 401(k) every year will get you well on your way to financial freedom.
But if you happen to be over 40 and are enjoying a nice run in your business, you have options that are simply not available to the rank and file.
OPTIONS TO MAX OUT YOUR ACCOUNT
Al has a 401(k) plan, just like you and me. And he maxes his account out every year.
But he also pairs his 401(k) plan with a good old-fashioned defined benefit pension plan and gets to dump in an extra $100,000 as a result.
These are how the numbers shake out.
As I mentioned earlier, the current maximum salary deferral in a 401(k)plan is $19,500. That max gets bumped up to $26,000 if you’re 50 or older — though my friend Al is not.
Additionally, he’s able to stash away up to 6% of his salary via profit sharing, which also gets put in the 401(k) plan. The IRS caps the salary you can use in the calculation at $285,000, making his maximum profit-sharing contribution $17,100 for 2020.
It’s worth mentioning that his income is much higher than $285,000, but the IRS limits the salary you can use for matching or profit-sharing purposes to that figure.
Between the 401(k) salary deferrals and the profit-sharing, he’s able to shield $36,600 from the taxman in 2020.
And now let’s get to the fun part.
THE ART OF SUPERSIZING
He supersizes his account with an additional $100,000 by contributing to a defined benefit pension plan. If he was older and closer to retirement, that number could actually be a good deal higher.
Traditional defined benefit pension plans are a nightmare for companies to administer and can be wildly expensive. This is why most large companies have opted to drop them and switch to defined contribution plans like 401(k)s.
But you wouldn’t necessarily mind the burden of funding a pension plan if you were the plan’s only participant and all the benefits went directly to you. And that’s exactly how this arrangement works.
With the help of a professional, Al created a pension plan in which he is the only participant. Under current actuarial assumptions, he’s able to contribute about $100,000 per year, all tax free. When the plan reaches a value of approximately $3 million, he’ll have to stop making new contributions. At that point, he can simply shut down the plan and roll it into a traditional IRA plan to avoid the hassle of administering the pension.
If any of this sounds complicated… it’s because it is.
Don’t try setting one of these up without professional help because mistakes can be costly and result in tax penalties. The good news is that there are plenty of companies that specialize in setting up these kinds of arrangements, and the costs generally aren’t unreasonable.
A COUPLE THINGS TO KEEP IN MIND
First, the existence of the defined benefit plan slightly reduces the amount of money you can stash into a 401(k) plan. Between salary deferrals and profit-sharing, you can put up to $57,000 into a 401(k) plan in 2020, or $63,500 if you’re 50 or older.
Under my friend Al’s arrangement, he can only contribute $36,600. But he can dump the extra $100,000 into the defined benefit plan, bringing his total to nearly $140,000.
So, unless you’re wanting to put more than $63,500 into your retirement plan, it doesn’t make sense to mess with the defined benefit plan.
Again, this isn’t something you’d want to try alone. You really need a professional actuary to verify the numbers lest you get yourself into a real tax mess.
Disclosure: Interactive Advisors does not provide tax advice and does not in any way represent that any specific investments will result in any particular tax consequences