Ted is age 53 and he is married to Jennifer age 45 and they live in a suburb of Boston Massachusetts. Ted is a self employed consultant and receives a 1099 as an independent contractor. In 2017 he anticipates he will make $400,000 of net income after business expenses. Jennifer works in banking and depending on her bonus makes between 400k to 650k per year. Ted wants to maximize his retirement contributions since they don’t need all of his income to maintain their lifestyle. Also, he wanted to maximize his tax deductions since they are in the 39.6% federal tax bracket.
Ted is a great candidate for a DB plan in 2017, but the twist to his story happens in 2018. Ted is a lawyer, but hasn’t practiced for several years, however in 2018 Ted is going to make a career change and start a legal practice as a sole proprietorship. Ted is going to work with another attorney who is interested in retiring and is looking for a succession plan for her clients. Based on the revenues of the existing legal practice and the terms of their agreement Ted anticipates 100k of net income in 2018, 200k of net income in 2019 and 300k of net income in 2020.
Ted’s goal was to make a large contribution based on his high income in 2017 and also wanted to make significant contributions in 2018 and 2019 despite his lower anticipated income from his legal practice.
Based on 400k of net income the total 2017 contribution is $236,164 ($202,164 DB plan + $24,000 401k + $10,000 profit sharing)
Contribution Estimates for Year 2 and Year 3
Ted wanted to get an idea of what the annual contributions would look like for Year 2 and Year 3. A fully insured defined benefit plan earns a guaranteed minimum rate, in this case 3% for this annuity. The guaranteed minimum rate makes it much easier to estimate future required annual DB plan contributions. Since the interest rate is fixed there is one less variable impacting the contribution. The estimates below were based on Ted’s anticipated 100k of net income for 2018 and 200k of net income for 2019.
Based on 100k net income the 2018 contribution is $90,048 ($69,048 DB plan + $21,000 401k +$0 profit sharing)
Based on 200k net income the estimated 2019 contribution is $128,894 ($100,394 DB plan + 24k 401k + $4,500 profit sharing). The DB contribution in Year 3 is based on a cash value of $279,348 (the two previous year contributions plus interest)
Ted liked this solution because it satisfied several goals:
- He was able to aggressively save for retirement which is his primary goal and made an annual contribution of $236,164 in 2017.
- In 2017 he was able to get a $236,164 tax deduction. Based on a 39.6% marginal tax bracket this saved him $93,520 in federal taxes.
- He was able to set up a plan that allowed him to make a significant contribution in Year 1, but also allowed him to make significant contributions in 2018 and 2019 despite his lower income.
- He liked that with the fully insured plan he could anticipate future required annual contributions. This made him feel more comfortable making large annual contributions since he didn’t have to worry about investment volatility impacting the required annual contributions. He felt he had enough to think about with the startup of his new law firm.
Here are case studies providing more examples.