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Is it wise to set up a Pension (in addition to 401K) if you are self employed?

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  • Is it wise to set up a Pension (in addition to 401K) if you are self employed?

    I am relatively new to investing and just became an owner of an orthodontic practice. I aspire to be a super-saver and am relatively frugal. If I am already maxing out my HSA, Back Door Roth IRA, 401K... I have been told that I can also set up a company pension for myself and my staff. I was told that I will have to test out the rules and will likely have to pay 15K to my staff if I would like to put away 70K pretax for my spouse and myself, but isnt that better than paying the tax on that 70k. I know I haven't read every single article on this site but I am surprised I haven't seen more about this from Dr Dahle with all the talk about maximizing tax-protected space. If anyone has any advice or experience with setting up a pension for a self employed doc, I'm all ears.

     

  • #2
    Google Defined Benefit Plan. It's not as simple a decision as the calculation you are presenting - for example, you will be paying the tax on that $70k, just not now. It is also an expensive endeavor, but can have a big payoff in the right situation. There are many factors involved plus it doesn't make sense until you are at least age 37 or 38 so it is not a topic that is of as much interest to a diverse audience, and that's probably why you're not seeing much on WCI.
    Working to protect good doctors from bad advisors. Fox & Co CPAs, Fox & Co Wealth Mgmt. 270-247-6087

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    • #3




      I am relatively new to investing and just became an owner of an orthodontic practice. I aspire to be a super-saver and am relatively frugal. If I am already maxing out my HSA, Back Door Roth IRA, 401K… I have been told that I can also set up a company pension for myself and my staff. I was told that I will have to test out the rules and will likely have to pay 15K to my staff if I would like to put away 70K pretax for my spouse and myself, but isnt that better than paying the tax on that 70k. I know I haven’t read every single article on this site but I am surprised I haven’t seen more about this from Dr Dahle with all the talk about maximizing tax-protected space. If anyone has any advice or experience with setting up a pension for a self employed doc, I’m all ears.

       
      Click to expand...


      I'm actually writing a comprehensive CB article for WCI on CB plans, it is done and has to be reviewed by an actuary/TPA.  There is a short answer and a long answer.  The short answer is that you need a comprehensive design study done, and you might or might not benefit from having a CB plan depending on the numbers.  Usually, those under 35 should not even consider a CB plan, and ideally you should be 40 or older.

      The long answer is that it has to work as part of your overall financial situation.  Depending on how old you are, such a plan might not make any sense.  It also depends on how long you plan to work and on your cash flow, and whether you can sustain making ongoing contributions into the plan.  The goal of a typical solo practice CB plan is to max it out over 10 years, and usually this is done prior to retirement, though if you are old enough and have the cash flow, it might make sense to do so earlier.

      Before setting this type of plan, you really need to understand how it works, and what's involved in running both plans.  The first step is to get a good actuary to do a design for the plan. Your current TPA might not be experienced enough in administering both plans. If your 401k plan is not custom-designed, your plan document might have to be amended to work with a CB plan. Also, a CB plan would require opening a pooled account since all of the investment are managed together.  You still have time to consider a CB plan in 2018, but I would spend the time to figure out all of the moving parts first, so that you understand how this plan will work for you in the long run, not just for a single year or two (you can't have this plan shorter than about 3-4 years, not only because IRS doesn't like this, but also because of the cost involved in opening and closing it).

       
      Kon Litovsky, Principal, Litovsky Asset Management | [email protected] | 401k and Cash Balance plans for solo and group practices, fixed/flat fee, no AUM fees

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      • #4
        It is possible to have too much money in tax deferred plans.

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        • #5




          It is possible to have too much money in tax deferred plans.
          Click to expand...


          Not really, no.  If you also do backdoor Roth and have after-tax investments, and are also in the highest brackets, tax-deferred is the way to go, so one should use any opportunities to max that out.  There is a thread on Roth vs. tax-deferred that's active, and there is a big discussion on the pros and cons of doing each, but having a CB plan in addition to a 401k can potentially allow one to contribute more Roth into the 401k plan, so there are definitely benefits to maxing out the tax-deferred space.  Also, CB plan has a lifetime maximum thats ~$3M or so, thus you can't put any more than that in it anyway, and 401k plan is also limited, so you are pretty much left with after-tax as a major bucket if you max out the CB plan.  Also, most docs won't get to $3M because you have to be around 57 to put this much in a CB plan.  Those starting out earlier will have a lower maximum amount.
          Kon Litovsky, Principal, Litovsky Asset Management | [email protected] | 401k and Cash Balance plans for solo and group practices, fixed/flat fee, no AUM fees

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          • #6
            I disagree.  Tax arbitrage is a powerful tool. How can you know what tax rates will be when you retire? The ability to selectively tax gain harvest AND tax loss harvest is wealth building.

            Having huge amounts in DC/DB plans means big RMDs in retirement.

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            • #7




              I disagree.  Tax arbitrage is a powerful tool. How can you know what tax rates will be when you retire? The ability to selectively tax gain harvest AND tax loss harvest is wealth building.

              Having huge amounts in DC/DB plans means big RMDs in retirement.
              Click to expand...


              That's a valid point, but there is a better approach than what you are advocating (and harvesting losses misses a huge issue of selling and buying at just the wrong time, so while getting tax advantage you lose when you get the timing of the purchases/sales wrong, which can easily offset any tax advantages). Also, tax-deferred easily beats after-tax, regardless of what you do with it. I'm assuming a buy and hold approach in my analysis because it is relatively tax efficient to implement after-tax. I'm reposting my reply in the Roth vs. tax-deferred thread:

              "Here's another way to look at this whole topic. Instead of worrying about future tax rates (we can't predict those, so don't even try), we can instead use 'bounded rationality' argument. It goes like this. If we DO NOT know something, how should we act based on this obvious lack of information?

              The answer is that we diversify. In this case we diversify our future tax liability. It is done as follows:

              1) Set up buckets, including backdoor Roth, tax-deferred and after-tax (this one is key). If you are in the highest rackets, you can safely do tax-deferred. Even if brackets are higher, your actual tax RATE will be lower in retirement, unless you will have tens of millions in various investments that are generating income. Even then you can structure a lot of your liquid investments to generate tax-free income (municipal bonds).

              2) Why after-tax? Well, at some point you might be in a lower tax bracket closer to retirement (or just in retirement). Ideally this is prior to age 70 and 1/2. You can then start doing massive Roth conversions. At that point you'll at least have some idea as to what the rates would be in the near future (which could be several decades from now), so you can decide on whether you want to convert part or all of your tax-deferred assets to Roth. Again, bounded rationality: no data, diversify, so you can convert some of the tax-deferred holdings to Roth and prepay the tax using your AFTER TAX money (to avoid spending the tax-deferred money on that). You will need a lot of liquid after-tax money to pay the taxes on this conversion.

              What will it buy? You will prepay taxes on the Roth conversion, and bet that if you live long enough, the massive Roth IRA you would gain is going to more than pay for itself and save you large amount in unnecessary RMD taxes paid. I'm getting numbers nearing $1M in taxes saved if you live into the 90s for a roughly $3M in tax-deferred assets. Again, this is using last years' brackets, and who knows whether the actual savings would materialize, but you can position your strategy in such a way as to be oblivious to any changes in tax situation because half of your assets would be Roth and half-tax deferred, so whatever happens, you'll at least be 50% right (which is better than 100% wrong).

              So with this approach you can wait until you are near retirement to make Roth conversions without having to worry about it now. Another strategy is if you have a Cash Balance plan that you are maxing out, you can (under the cover of high CB contributions) sneak in some Roth into your 401k plan. Or if you have a very low income year, you can convert some of your 401k plan money to Roth inside your plan. Especially inside your 401k plan that you control, you can make tax-deferred contribution, and then if you change your mind, you can convert that to Roth. So there are many ways this game can be played.

              Trying to predict the future is pointless, but that does not mean you can't position your strategy to take advantage of whatever happens in the future without taking excessive risk of being wrong."
              Kon Litovsky, Principal, Litovsky Asset Management | [email protected] | 401k and Cash Balance plans for solo and group practices, fixed/flat fee, no AUM fees

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