Stashing thousands in defined benefit plans, law partners,wealth managers and others are trying to get around the incomelimits Congress created to bar them from a generous new tax breakfor owners of pass-through entities, who report the firms' incomeon their individual tax returns. (Photo: Shutterstock)

(Bloomberg) –There's one area where the traditional pension planis getting new life — as a tax dodge for wealthy businessowners.

Defined benefit plans can be used by doctors, law partners andwealth managers to stash hundreds of thousands of dollars in incomea year. By doing so, they'll get around the income limits Congresscreated to bar them from a generous new tax break for owners ofpass-through entities, who report the firms' income on theirindividual tax returns.

The Treasury Department proposed regulations last weekspecifying who qualifies for the 20 percent deduction, whicheffectively slashes the top tax rate to just under 30 percent from37 percent.

The rules also say that planning techniques such as the “crackand pack” — where business owners split their firms into differententities to lower their tax bills — are considered abusive.

That's pushing top-earning service professionals to figure outother ways to get below the income limits of $315,000 if they'remarried, or $157,500 if they're single, so they can take fulladvantage of one of the tax law's biggest gifts. One of theworkarounds is a retirement plan more associated with unionworkers.

Tax reform increasing popularity of cash balanceplans

“Doctors and lawyers got really annoyed when they were excludedfrom the pass-through deduction,” said Daniel Kravitz, president ofretirement plan administrator Kravitz. “After tax reform, theseplans become even more beneficial.”

Kravitz said his firm, a specialist in defined benefit plans forsmall businesses, is actively marketing pensions as a way forservice professionals to get around the new rules. Before the taxoverhaul, clients typically used them to defer paying taxes onincome.

Defined benefit plans are generally set up in the last fewmonths of the year, but Kravitz said he's already having hisbusiest sales year ever, as clients start new pensions called cashbalance plans and boost contributions on existing plans.

With a cash balance plan, participants know each year how muchthey individually hold. Employers make contributions according to aset formula and manage all participants' investments collectively,usually guaranteeing a set return.

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

Many large law firms and medical groups already offer cashbalance plans to help their highly paid partners lower their taxbills. While these professionals may boost contributions, ifpossible, to try to take advantage of the pass-through deduction,the biggest potential opportunity under the new law is for thethousands of smaller businesses that don't yet have suchofferings.

Even before the tax law, the popularity of cash balance planswas surging for small business owners. There were 20,500 such plansin 2016, up almost threefold since 2010, according to Kravitzestimates based on Internal Revenue Service data.

The majority are run by businesses with fewer than 10 employees;37 percent of plan holders were doctors or dentists, while 10percent were accounting, finance or insurance firms and ninepercent were legal firms. One of the biggest players in the spaceis Kravitz's parent Ascensus, which has acquired 20 retirementservice firms in recent years.

The interest is a change for the traditional pension plan, whichhas been slowly dying after most big U.S. employers replacedguaranteed retirement benefits with less-costly 401(k) retirementaccounts.

Defined benefit pensions can shield more income from the IRSthan a 401(k)-style defined contribution account or individualretirement account, or IRA. Annual employee contributions arecapped at $18,500 this year for 401(k)s and $5,500 for IRAs forthose under 50.

A cash balance pension is the “next logical step” for successfulbusiness owners who are already funding their 401(k) profit-sharingplans up to their limits and want to avoid taxes by deferring evenmore income, said Keith Steidle of Steidle Pension Solutions, asmall plan administrator based in New Jersey.

A 61-year-old married doctor with a practice earning $650,000 ayear could set up a defined benefit pension to get his taxableincome under $315,000. He could put $268,000 in a cash balancepension, in addition to putting money in his 401(k) andcontributing to employee retirement accounts, and get down to aneffective tax rate of 20 percent, according to Kravitz'scalculations.

After several years of saving in a cash balance plan, recipientsgenerally roll their account balance into an IRA and manage themoney themselves. Most choose to do so since the IRA is a morecost-effective vehicle and they can invest more aggressively thanin a cash balance plan. There's no limit on how much users can rollover. They don't pay taxes until they pull the money out, typicallywhen 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 pensionworkaround. Like other retirement plans, defined benefit plans aregoverned by regulations, called non-discrimination rules, thatrequire owners to spread at least some retirement wealth tolower-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'sowner will require a profit-sharing retirement contribution formiddle-class employees equal to about 7.5 percent of theirsalaries. A cash balance plan can be too expensive, therefore, forlarger businesses with many low earners.

For small, profitable professional businesses, however, the vastmajority of the benefit can usually go to owners, not employees. Ifthe doctor's office that brings in $650,000 employs four peopleearning from $21,000 to $51,000 a year, retirement rules dictatethat those four employees would split an annual retirementcontribution from the doctor of $13,825.

Setting up a cash balance plan isn't the right strategy forevery business. Owners must be sure of stable, consistent profitsbefore they commit to funding several years of pensioncontributions, said Jamie Hopkins, a professor at the AmericanCollege 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 ofthe complex rules, it can cost thousands of dollars to set up andthen administer a defined benefit plan. Kravitz estimates thedoctor's office 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, though they canspread the costs over more partners or participants. Typically themoney is invested conservatively, guaranteeing a particular rate ofreturn, such as 4 percent a year.

For rank-and-file workers, the great appeal of a defined benefitpension is that it can guarantee a certain level of income forlife. Cash balance plans effectively offer the same thing, withrules requiring them to offer a way to convert pension balancesinto an income stream from an annuity. While the annuity option ofcash balance plans may appeal to lower earners, wealthyparticipants aren't interested.

“Nobody ever takes an annuity,” said John Lowell, a partner andactuary at October Three Consulting, referring to high-incomebusiness owners. “Ultimately, they are a tax play more than theyare a retirement plan play.”

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