Let me start by saying that I love the 401(k) plan. It’s the single best wealth accumulation vehicle available to the vast majority of Americans. At today’s contribution limits, you can defer $18,000 of income — and $24,000 if you’re 50 or older — tax free.
That’s great for middle-class Americans, and many can meet those goals with a little bit of discipline. But if you have an annual income of $500,000 or more, that amounts to a paltry savings rate of less than 4%. Any savings above that amount would be subject to punishingly high taxes…and even the dreaded ObamaCare surcharge.
Well, I have good news. If you earn a high income and own your own business (or are paid as a 1099 contractor), you have vastly superior savings options at your disposal. If done right, you can save well over $100,000 per year in tax-sheltered accounts.
This strategy is designed for the self-employed, but it can also work if you work for a paycheck but also earn additional income from a side business or additional contract income. A lot of doctors and consultants would fall under this umbrella.
We all know that the traditional defined benefit pension is dead. The days when your employer guaranteed you an income for life are now something we read about in history books.
Well, that might be true for corporate plans. But there is nothing stopping you from starting your pension for yourself and your spouse.
The One-Man Pension
The best retirement savings strategy is actually a combination of two separate vehicles:
- An Individual 401(k) plan with profit sharing
- A cash balance defined benefit pension plan
I’ll tackle the Individual (“Solo”) 401(k) plan first. Most investors consider a Solo 401(k) plan to be more or less interchangeable with a SEP IRA.
They’re wrong.
While both plans max out at $53,000 per year in contributions, the Solo 401(k) allows for front loading. I’ll explain with an example. Let’s say your business earns $100,000. With an SEP IRA, you can contribute 20%, or $20,000. This is a profit sharing contribution made on your behalf by your employer…which happens to be you.
With the Solo 401(k), you can make that same profit sharing contribution of $20,000. But you can also defer $18,000 of salary, for a total of $38,000.
Of course, we’re talking about high-income earners, and both the Solo 401(k) and the SEP IRA max out at $53,000 on incomes of $265,000.
So, if you earn $265,000 or more, the SEP IRA and Solo 401(k) are interchangeable, right?
Wrong!
If you save via a Solo 401(k), you are also eligible to contribute to a defined benefit plan. If you save via a SEP IRA, you cannot.
This brings me to the second prong of the retirement plan, the single-person defined benefit plan. Yes, you can actually make a traditional pension plan…for yourself. There are administrative fees involved, and you’ll want to hire a professional to draft the plan documents and monitor compliance. But doing all of this opens the door to massively increase your retirement savings.
Contribution levels here depend on your age and other actuarial assumptions, but this is how they shake out:
2016 Maximum Contributions to Cash Balance Pension
| Age | Maximum Contribution |
|---|---|
| 65 | $244,500 |
| 60 | $236,800 |
| 55 | $184,600 |
| 50 | $143,900 |
| 45 | $112,200 |
| 40 | $87,500 |
| 35 | $68,300 |
| Source: Dedicated Defined Benefit Services |
Putting It All Together
Combining the Solo 401(k) with the cash balance defined benefit plan is a little complicated, so I can’t stress enough the importance of hiring a knowledgeable pro to set it up correctly. But here are the basics.
Normally, you can contribute $18,000 in salary deferral and 20% of profits to a Solo 401(k) plan up to a maximum of $53,000. But if you also contribute to a cash balance pension plan, your profit sharing percentage gets bumped from 20% to 6%. That effective drops your $53,000 contribution to $33,900 if you’re under 50 and $39,900 if you’re 50 or older.
But here’s where it gets fun. If you’re 65 years old, your combined contribution to the Solo 401(k) and cash balance pension is a whopping $284,400 ($244,500 cash balance + $39,900 401(k) plan). The numbers get smaller the younger you get, but at age 35 you can still contribute a not-too-shabby $102,200.
Is There A Downside?
So, stashing away multiple hundreds of thousands of dollars per year sounds pretty great, right? What’s the catch?
Believe it or not, there really isn’t one. There are costs, of course. Expect to pay $2,000 to $3,000 in administrative expenses. And you need to have a fairly consistent income in order to make this work, as there can be penalties for failing to make contributions. So the plan is clearly not for everyone.
But if you are a high-income American desperate to shield some of your savings from the tax man, this is the best combination I’ve seen.
Charles Sizemore is the principal of Sizemore Capital Management. If you are interested in the savings vehicles discussed in this article, contact his office.