Pension plans are the new tax dodge for rich business owners

There’s one area where the traditional pension plan is getting new life: as a tax dodge for wealthy business owners.

Pension plans, also known as defined-benefit plans, can be used by doctors, law partners and wealth managers to stash hundreds of thousands of dollars in income a year. By doing so, they’ll get around the income limits Congress created to bar them from a generous new tax break for owners of pass-through entities, who report their firms’ income on their individual tax returns.

On Aug. 8, the Treasury Department proposed regulations specifying who qualifies for the 20% deduction, which essentially slashes the top tax rate to just under 30% from 37%. The rules also say planning techniques such as the “crack and pack” — in which business owners split their firms into different entities to lower their tax bills — are considered abusive.

That’s pushing top-earning service professionals to figure out other ways to get below the income limits of $315,000 if they’re married, or $157,500 if they’re single, so they can take full advantage of one of the tax law’s biggest gifts. One of the workarounds is a type of retirement plan associated more with union workers.

“Doctors and lawyers got really annoyed when they were excluded from the pass-through deduction,” said Daniel Kravitz, president of retirement plan administrator Kravitz Inc. “After tax reform, these plans become even more beneficial.”

Mr. Kravitz said his firm, a specialist in defined-benefit plans for small businesses, is actively marketing pensions as a way for service professionals to get around the new rules. Before the tax overhaul, clients typically used them to defer paying taxes on income.

Defined-benefit plans are generally set up in the last few months of the year, but Mr. Kravitz said he’s already having his busiest sales year ever as clients start new pensions called “cash-balance plans” and boost contributions on existing plans.

With a cash-balance plan, participants know each year how much they hold. Employers make contributions according to a set formula and manage all participants’ investments collectively, usually guaranteeing a set return.

The contribution limits are based on age. Generally, workers in their 30s and early 40s can pitch in less than $100,000, but limits for older workers rise quickly, to above $200,000 for those in their late 50s and above $300,000 for those in their late 60s.

Many large law firms and medical groups already offer cash-balance plans to help their highly paid partners lower their tax bills. These professionals may boost their contributions, if possible, to try to take advantage of the pass-through deduction, but the biggest potential opportunity under the new law is for the thousands of smaller businesses that don’t yet have such offerings.

Plan popularity surging

Even before the tax law, the popularity of cash-balance plans was surging for small-business owners. There were 20,500 such plans in 2016, up almost threefold since 2010, according to Kravitz Inc. estimates based on Internal Revenue Service data. The majority of such plans are run by businesses with fewer than 10 employees; 37% of plan holders were doctors or dentists, while 10% were accounting, finance or insurance firms and 9% were law firms.

The interest is a change for the traditional pension plan, which has been slowly dying after most big U.S. employers replaced guaranteed retirement benefits with less-costly 401(k) retirement accounts.

Defined-benefit pensions can shield more income from the IRS than a 401(k)-style defined-contribution account or individual retirement account. Annual employee contributions are capped at $18,500 this year for 401(k)s and $5,500 for IRAs for those under 50.

A cash-balance pension plan is the “next logical step” for successful business owners who are already funding their 401(k) profit-sharing plans up to their limits and want to avoid taxes by deferring even more income, said Keith Steidle of Steidle Pension Solutions, a small plan administrator.

A 61-year-old married doctor with a practice earning $650,000 a year could set up a defined-benefit pension to get his taxable income under $315,000. He could put $268,000 in a cash balance pension, in addition to putting money in his 401(k) and contributing to employee retirement accounts, and get down to an effective tax rate of 20%, according to Kravitz’s calculations.

After several years of saving in a cash-balance plan, recipients generally roll their account balance into an IRA and manage the money themselves. Most choose to do so because the IRA is a more cost-effective vehicle, and they can invest more aggressively than they could in a cash-balance plan. There’s no limit on how much users can roll over. They don’t pay taxes until they pull the money out, typically when they’re in retirement and in a much lower tax bracket.

Lower-paid employees

The rich aren’t the only ones who can benefit from the pension workaround. Like other retirement plans, defined-benefit plans are governed by regulations, called “non-discrimination rules,” that require owners to spread at least some retirement wealth to lower-paid employees.

The rules depend on the age and income levels in a workforce, but typically setting up a cash balance pension for a business’s owner will require a profit-sharing retirement contribution for middle-class employees equal to about 7.5% of their salaries. A cash-balance plan can be too expensive, therefore, for larger businesses with many low earners.

For small, profitable professional businesses, however, the vast majority of the benefit can usually go to owners, not employees. If the doctor’s office that brings in $650,000 employs four people earning $21,000 to $51,000 a year, retirement rules dictate that those four employees would split an annual retirement contribution from the doctor of $13,825.

Setting up a cash balance plan isn’t the right strategy for every business. Owners must be sure of stable, consistent profits before they commit to funding several years of pension contributions, said Jamie Hopkins, a professor at the American College of Financial Services.

No annuities

Businesses also need to make sure they’re cutting their owners’ tax bills enough to make up for pensions’ higher costs. Because of the complex rules, it can cost thousands of dollars to set up and administer a defined-benefit plan. Mr. Kravitz estimates the doctor’s office in the example above would be charged a one-time set-up fee of $5,500 and annual fees of $8,880.

Charges can be much higher for larger firms, although they can spread the costs over more partners or participants. Typically, the money is invested conservatively, guaranteeing a particular rate of return such as 4% a year.

For rank-and-file workers, the great appeal of a defined-benefit pension is that it can guarantee a certain level of income for life. Cash-balance plans essentially offer the same thing with rules requiring them to offer a way to convert pension balances into an income stream from an annuity. In practice, the wealthy participants in cash-balance plans aren’t interested.

“Nobody ever takes an annuity,” said John Lowell, a partner and actuary at October Three Consulting. “Ultimately, they are a tax play more than they are a retirement plan play.”

(More: Tax law: How to get the pass-through deduction by reducing taxable income)