As seen in Tax Hotline

Defined-Benefit Plans Got A Big Lift from The 2001 Tax Law
By Richard K. Newman, CPA
Newman + Cohen Financial Management

The 2001 tax law has gone into effect, with its higher limits on retirement plan contributions. Most of the media attention has been focused defined-contribution (DC) plans...

	401(k) plans now permit salary deferrals up to $11,000 per year, rising to $15,000 a year by 2006, People age 50 or older can contribute an extra $1,000 this year, $2,000 in 2003, going to $5,000 in 2006.
	Profit-sharing plans now permit contributions up to $40,000 per year But defined-benefit (DB) plans may permit even larger deductible contributions. If you are over age 50 and highly compensated, six-figure contributions may be allowable.

Defined-benefit plans are traditional pension plans. They're designed to pay retirees a certain amount, based on earnings and length of service. To deliver the promised pension, sizable amounts have to be accumulated in the plan.

Example: Joan Jones qualifies for a $100,000 annual payout from her defined-benefit plan when she retires. To make these payments, her employer will have to contribute and accumulate in the plan $1 million, $2 million, or more, by the time she retires. (Various assumptions will determine the exact amount.)

Higher and higher

Several provisions in the 2001 tax law boosted defined-benefit plans...

	Higher limits. The maximum benefit payable under a defined-benefit plan is $160,000 per year. That's up from $140,000 in 2001. This limit will increase with inflation, in $5,000 increments. Thus, when inflation has risen by a cumulative 3.125%-probably in 2004- the PB limit will hit $165,000. Ever-higher ceilings are likely. Key: The higher the DB payment, the more that can be contributed (and deducted) currently. Caution: Your payment from a DB plan can't exceed your peak earnings.
	Earlier retirements. Under prior law, the $140,000 maximum PB payment was reduced if you retired before age 65. Now, you can retire as early as age 62 and get the maximum benefit. Indeed, if you retire after age 65, your PB payments can exceed the current limit. Again, if you plan to retire at age 62 rather than age 65, higher contributions are necessary.
	Greater compensation. As is the case for all retirement plans, compensation up to $200,000 may be taken into account for purposes of determining how much you can contribute. Last year, the upper limit was $170,000. The limit will increase in $5,000 increments, with inflation. This number likely will reach $205,000 in a year or two.
	Larger deductions. There are actuarial limits on deducting contributions in excess of a plans current liability These limits have been eased and will disappear after 2003. Bottom line: The interaction of these new rules allows much larger DB contributions now. Example: Ted Peters, 58, earns more than $200,000 per year. He wants to create a DB plan. Under the 2001 rules, he could have contributed about S225,000-this year, his deductible Contribution will be more than $290,000.

DBs for self-employeds

If you're self-employed, you can create a defined-benefit plan for yourself. Generally if you're over 40, you'll be able to put more into a DR plan than the current $40,000 ceiling for DC plans.

The older you are, the greater the advantage of a DB plan over a DC plan.

For employers: If you run a business or professional practice, you can adopt a DB plan. In such cases, you must contribute for your employees as well as for yourself.

Loophole 1: It is permissible to set up a vesting schedule for DB participation. Doing so will reward longtime employees but not short-timers.

In fact, employees who leave the company will forfeit unvested benefits, and such forfeitures will reduce the amounts your company will have to contribute.

Loophole 2: You can restrict employees with less than two years of service, union members, non-US citizens, and part-time workers from being eligible for the DB plan.

On the other hand, a DB plan can help motivate loyal employees. Considering the uncertainty of stock market returns after a two-year bear market, the security of a DB pension might be very appealing.

DB plans generally work better for company principals if they are much and more highly paid than rank-and-file employees.

Example: If you're in your 50s, you might make a six-figure contribution toward your own pension, yet contribute only a few thousand dollars for your 20-something receptionist.

Bonus benefit: You might structure a DB plan that will pay a benefit to your surviving spouse as well as to yourself. Again, that may tilt contributions in your favor, especially if most of your employees are unmarried.

Two for the money

If you decide to adopt a DB plan, you have two options...

	Traditional DB plan. For this type, you may invest in a range of securities. Investing in bonds reduces the risk your plan will lose money Also, by investing in relatively low-return bonds, you increase the amount you'll have to contribute (and deduct) in order to reach your accumulation targets.
	412(i) plans. These plans must be funded with insurance products. Often, contributions are invested in fixed annuities.

Which plan is better for you? That depends on two factors...

	Age. Traditional DB plans may allow larger contributions for people in their 40s while 412(i) plans may be better if you're in your 50s or 60s.
	Size of company. With no more than five employees, a 412(i) plan may result in greater skewing of benefits to you, as owner-employee. With six to 10 employees, a traditional DB plan may work better. Caution: Larger companies may find it very expensive to provide a DB plan for employees.

Shifting gears

Your company may already have a DC plan in place. Indeed, as long as you were in your 20s and 30s, such a plan was the better choice.

What do you do now, if you want to adopt a DB plan? Two choices...

	Freeze the old DC plan. You would make all ongoing contributions to the DB plan. The DC accounts may continue to grow, until they're ultimately distributed to individual participants.
	Maintain two plans. In some cases, it may be possible to contribute to a DB and a DC plan, increasing the tax shelter. Check with an employee benefits pro to see if it's worthwhile to sponsor both plans.

Sponsoring disadvantages

DB plans require actuarial updates each year, which may be expensive. You'll have to determine whether the extra tax shelter you'll receive will be worth the price.

DB plans require substantial funding, year after year. Thus, they're best suited for businesses and professional practices with dependable income.

If your business is volatile, you may not want to be required to make a large contribution in a bad year It's true that DB plans can be amended, if necessary, but extra expense and effort will be involved.

Bottom line: The best candidates for DB plans are older professionals and business owners who have substantial incomes, year after year, and a much younger work-force with high turnover.

Professional practices with few or no employees may reap benefits from DB plans.