[Blog] It’s Never Too Late to Accelerate Your Retirement Savings

High income earners can make up ground quickly with the Defined Benefit Plan.

By Ed Meek, CFP and James Alexander, CFP at Edge Financial Advisors

It’s one of the first principles of the universe: the more money you make, the more taxes you pay.

That’s especially true for high-income earners, and the numbers can be staggering. A health insurance broker who had several high-income years after struggling through the early years of his business was now making more than $500,000 a year. Routinely, he had to ante up about $40,000 every April 15^th to cover his tax liability.

The game for high-income earners is how to defer your taxes while saving more for retirement.

Fortunately, there is an IRS-approved game to be played. It’s called the Defined Benefit Plan. It’s not for everyone, but if you qualify, you could save as much as $265,000 or more (in 2023) per year in tax-deferred savings.

An Overview of Retirement Plans

Before we dig into the Defined Benefit Plan, we want to make sure that you know the basics of retirement savings. Here are the key vehicles for socking away money for retirement for self-employed individuals and entrepreneurs:

Basic IRAs. Traditional and Roth IRAs are familiar plans to anyone considering retirement. Many people who receive retirement benefits through an employer also supplement their savings with an IRA.

The main difference between a traditional IRA and a Roth IRA is taxation. Contributions in a traditional plan are tax deductible in the year you make them, but the income in retirement is taxable. The Roth IRA reverses this arrangement, making withdrawals in retirement tax-free.

For many solopreneurs, the contribution limits on these accounts are too low for significant tax relief. In 2022, individuals could only contribute $6,000 per year or $7,000 for those over 50 years old. If you had started contributing to a basic IRA at a young age, it might have grown over the years. However, solopreneurs closer to retirement will want a better solution.

SEP IRA. A Simplified Employee Pension plan is a form of IRA with the same tax model as a traditional IRA. Delaying taxes until retirement is a good plan if you expect to be in a lower income bracket later in life.

As a self-employed person, you contribute to a SEP IRA as the employer. You can invest up to 25% of your self-employment earnings with a maximum contribution of $61,000 in 2022.

Solo 401k. A Solo 401K is another option for high-income, self-employed people. Like the SEP IRA, you make pretax contributions and have taxable retirement income. It also has the same contribution limit: $61,000 in 2022. However, the Solo 401k has an additional catch-up contribution of $6,500 for people over 50.

In this plan, you make contributions as both employer and employee. As an employee, you can contribute up to 100% of your compensation with a limit of $20,500. Other contributions come from the profits of the business as the employer.

You cannot use a Solo 401k if you have employees. However, if you and your spouse are partners in the business, you can both contribute to the same plan for a total of $122,000 pretax contributions each year.

The Retirement Accelerator

Here is where you can accelerate your retirement savings by deferring a large chunk of your income for tax purposes. The accelerator is the Defined Benefit Plan, one of the best kept secrets for high- income earners.

As the owner of a profitable business, you may currently be in one of the highest tax brackets. This account lets you postpone paying those taxes until you enter a lower tax bracket in retirement. The investment growth in the fund is also tax-deferred. You will not lose money to taxes until you start receiving income from the fund.

This retirement plan allows you to make large tax-deferred contributions while preparing you for the future. This is especially powerful for high-income earners who are approaching retirement.

But not all high-income earners qualify.

The IRS has some rules: If you are a high-income self-employed individual, you may qualify. So may an independent contractor who reports income from IRS Form 1099. In addition, a small business owner with full-time employees may also qualify; however, you will also need to contribute to the fund on their behalf.

This requirement, of course, can make the plan expensive to maintain, and you will need to analyze your profits to be sure you can support the fund without hurting the business. The rule does not apply to part-time employees.

How to Get Started

The first step is to see if you qualify. That’s easy to do. In fact, you can take our “Retirement Accelerator Quiz,” which is an easy, initial way to kickstart the process. See the link below for more information on our simple quiz.

Next, you’ll want to recruit a financial advisor who specializes in the Defined Benefit Plan to help determine the age you expect you retire and your anticipated benefit in retirement. The advisor will help you connect with an actuary for this part of the process. Federal rules require that you use an actuary to take these numbers and calculate your contribution amount. You will fill out a questionnaire about your organization, and they will take your information and create a plan with a tax ID number. Your actuary must file annual paperwork to keep the account in IRS compliance.

Once the fund is in place, you start making contributions. When you create the plan, you want to be certain that you can fund it for at least three years. After this, you may terminate the account if times change and it becomes too difficult to pay. Through your actuary, you can also change the terms to lower the contributions or extend the time until your retirement.

A professional financial advisor can be the quarterback for helping you develop a strategy that maximizes your benefits while minimizing taxes.

To take our quiz to see if you qualify for the Defined Benefit Plan, visit https://www.yourretirementaccelerator.com/defined-benefit-plan-quiz.