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Tax Shelters are Back and This Time They're Legitimate By Stephen J. Butler

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Many years ago, MEDICAL ECONOMICS magazine ran an article about the number of doctors who were serving time in minimum-security federal prisons for tax evasion. For the most part, these were professionals who had developed the habit of accepting cash payments from patients and not reporting it. The IRS, when auditing, just asked to see a month of appointments -- any month - and they would systematically call all the patients seen that month to ask if they had paid with cash or a check. After that, only the combination of simple arithmetic and honesty stood between the doctor and the slammer. And then there was Jerry on the old Bob Newhart show who returned his living room couches to the waiting room of his dental office. He was being audited and had to prove that the furniture costs he had deducted were clearly for business purposes.

Thanks to the new pension laws enacted for 2002, older professionals and small business people can relax. They can report all income and take just legitimate deductions. Why? Because income on which they would prefer to defer taxes can be contributed into a retirement plan. Anyone over fifty years of age is close enough to retirement to be concerned about the reversal of fortune they have experienced over the past two and a half years. Today, some aggressive pension planning can offer the corrective measure that will get those original retirement income projections back on track.

There are three stages of annual contribution limitations. The first is the well-known 401(k) annual contribution limitation of $12,000 for folks over fifty this year. In four years, that maximum will have graded up to $20,000. The second maximum is the total of $40,000 which is the combined total contribution of both the voluntary 401(k) and employer contributions. The third stage is that created by a defined benefit plan allowing the employer to fund for a specific retirement benefit. This type of plan could allow contributions that are "off the charts" (over $200,000 per year, for example) depending upon the business-owner's age and current income.

The application of these different retirement plan alternatives hinges on the mix of employees and their ages relative to that of the business owner or professional who hopes to maximize his or her contribution.

In simple terms, here's how these more aggressive plans work: A business owner who wants a $160,000 per year retirement benefit is allowed to accumulate approximately $1.9 million in a retirement plan. Today's annuity tables have shown that this is the amount needed to guarantee a lifetime income of $160,000 per year (the maximum allowable benefit.) While most retirees would elect to live on any interest earnings from this money and maintain the principal, anyone could actually purchase an annuity from an insurance company that would guarantee $160,000 per year for life even if they live as long as Senator Strom Thurman.

For a fifty-year old person to accumulate $1.9 million in fifteen years, he or she would have to contribute about $82,000 per year assuming a compound rate of return of 6% interest on what they contributed. In other words, $82,000 per year earning 6% accumulates to $1.9 million. If the same person waited until age 58 to start the annual contribution cost with just seven years of time would be $226,000 --- all tax-deductible. Contributions of $226,000 each year for seven years and earning 6% would accumulate to $1.9 million.

A qualified retirement plan has to meet requirements that prevent it from discriminating in favor of company owners or highly-compensated employees. Therefore, the plan has to make an equivalent, but proportionate promise to all of its eligible employees. This means that an employee making $40,000 per year at age 30 would get the same ultimate retirement promise, but the arithmetic would be substantially different. This person has 35 years until a projected age 65 retirement. The funding objective is $475,000 - the amount required to fund a lifetime income of $40,000 beginning at age 65. The annual cost to fund this benefit is about $4,000. If the employee was only age 25 with 40 years to accumulate, the annual cost would only be about $3,000. These plans can be combined with 401(k) plans, so these younger employees can still contribute all or any portion of their annual 401(k) maximums.

A growing subset of our society (two-thirds of all California workers) is working in non-traditional employment modes (independent contractors, part-time jobs for spouses, etc.) that open the door to many creative uses of these new retirement plan opportunities. A 55-year-old independent contractor making $60,000 could defer $30,000 into one of these plans, for example. Someone working part-time as an independent contractor could defer all of their $12,000 annual income into a one-person 401(k).

Accountants and other advisors are struggling to get ahead of the curve on the tax-saving opportunities these new-for-2002 plans can offer. Finding a resource that can identify the optimal mix of work mode and retirement plan is not easy. Forget the brokerage firms and most financial institutions. Thirteen major financial institutions have left the pension consulting and administration business this year alone. The work is too difficult, and they have lost too much money trying to offer a sophisticated service as a loss-leader for selling investments. The best bet is to contact the American Society of Pension Actuaries (ASPA) in Washington for a list of local member firms. These are so-called "third party administration firms" that are independent of financial institutions and that perform pension consulting, actuarial work and retirement plan administration for a fee.

Thinking "out of the box" with regard to work mode and retirement plan opportunities can add several hundred thousand dollars, if not millions, to a retirement nest egg. By adopting the right combination, we can all accumulate more wealth by saving taxes (legally) and still get a good night's sleep.