Now the Self-Employed Can Sock Away More

A defined-benefit plan allows far bigger tax-deductible contributions

Are you self-employed? Your retirement options aren't limited to individual retirement accounts, Keoghs, or similar defined-contribution plans. Entrepreneurs, consultants, and other free agents are establishing traditional defined-benefit pension plans--the sorts that large corporations provide their employees. For those who can afford to stash bundles of cash, these plans are attractive. They permit tax-deductible contributions that far exceed the yearly $35,000 maximum allowed under the most generous defined-contribution plan.

The plans are ideal for people who want to shelter extra income for retirement. In dual-income households, a spouse who is a sole proprietor of a business can lower the joint tax bite by setting up a plan. It's also a way to lower taxes on income from a sideline business. "I've been able to play catch-up on my retirement," says Jane King, 57, president of Fairfield Financial Advisors Ltd. in Wellesley, Mass. Five years ago, she started socking away half of her $120,000 income annually.

With a defined-contribution plan such as a 401(k), you, and sometimes your employer, set aside a percentage of your income each year. The size of your kitty will then depend on how much you save and how well your investments perform. With a defined-benefit plan, you target a level of retirement income, and an actuary advises on how much you need to put away and how much the funds need to earn to hit your target. Your contributions may vary each year, depending on income and investment returns.

Under federal rules, the projected annual benefit is capped at up to 100% of net compensation or $140,000, whichever is less. (Congress recently raised the maximum to $160,000 at the end of 2002.) Compensation is based on an average of the three highest consecutive years of pay. So a person who averages $100,000, net of business expenses and the pension contribution, can target a yearly benefit of $100,000 or some percentage of that. To come up with the contribution, the actuary uses a formula that considers age, life expectancy, years until retirement, and an annual investment return of 6% or 7%.

Consider a 55-year-old who plans to retire at age 65 and get the maximum benefit allowed. She can make an annual contribution of $98,333, assuming an investment return of 7.5%, says Kenneth Anderson, a Concord (Mass.) actuary. Compare that to a Keogh, which lets you contribute 25% of compensation or $35,000, whichever is less. Still, a 40-year-old may find he'll save more tax-deductible dollars through an IRA or Keogh.

TEMPTING. With a self-funded defined-benefit plan, you'll need to pay an actuary as much as $1,500 to set it up and $750 or more a year to file reports and make adjustments with the Internal Revenue Service. If the plan is underfunded at retirement, you'll pay penalties--and you'll owe tax on the excess if you're overfunded.

If you want to alter your contributions as the years go by, the actuary can tweak the assumptions. For instance, "you can push up contributions by lowering the rate [of return]," says Bruce Marotta, an actuary in Port Orchard, Wash. Also, you can terminate the plan if circumstances change--say, you shut your business--and then roll over the funds into an IRA. But if you fiddle around too much, or if you end it in a year or two, the IRS could consider your plan a tax sham and hit you up for taxes and penalties.

Although big tax savings are tempting, make sure you can live on the income left after contributions. Sole proprietors who plan to hire employees anytime soon may want to steer clear of defined-benefit plans. Federal rules require that if an employer has a plan, some employees must be covered, too.

At retirement, you can take the lump sum and roll it into an IRA, withdrawing the money at will. Or you can buy an annuity that guarantees a lifetime benefit. Not only will your retirement be richer, that smaller tax bite will make the years leading up to it sweeter.

By Susan Garland

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