f STRUDWICK Wealth Strategies "Innovation Equals Opportunity" THE POWER EARNER'S TAX RELIEF PLAN by Barry Strudwick

Do miracles ever cease? After years of throwing small bones to small business owners, Congress has finally given us a substantial tax benefit. Buried deep within the tax bill passed last summer is a tax bonanza for small business owners and entrepreneurs who want to keep Uncle Sam's hand out of their pocket. Unlike the fantasy tax cut of "estate tax repeal," these benefits can be captured immediately in 2002.

While the media coverage focused on the small changes impacting the average Joe, the most potent changes impact "Power Earners" or self-employed people who make over $150,000 a year.

In a nutshell, the old "Defined Benefit" pension plans have been given a dose of Viagra after falling into disuse after repeated Congressional "soak the Fat Cats" meddling over the past 15 years. Now, faced with a crumbling Social Security system and aging workforce, Congress has quietly allowed a "back door privatization" of our nation's retirement system by dramatically increasing the tax deductible contributions small business owners can put away in their own retirement plans.

To understand these changes, we'll first have to cut through the jargon of the Tax Code. Most of us are familiar with "Defined Contribution" or "DC plans" where the employer makes a contribution based on a percentage of payroll. DC plans also include 401(k) plans where in addition to a contribution by the employer, the employee can also make a contribution with a pretax reduction of salary. Whatever accumulates in a DC plan by retirement age is what the employee has for retirement. No more, no less.

Almost forgotten over the past decade, Defined Benefit Plans are almost the inverse of DC plans. Here the annual tax deductible contribution is based on an actuarial calculation of how much would be required for a specific annual retirement income such as $50,000 or $100,000 a year. The bigger the retirement income target and the shorter the funding horizon, the greater your tax- deductible contribution is each year within IRS set limits

The key to the recent tax law changes is that the limits have been raised, effectively increasing the amount of tax-deductible contributions by over 50%. To bring the power of these changes into focus, let's look at an actual example of Will & Beth, a couple I met several years ago in New England when they had just "sold" their business to the children. Their plans were to travel and spend more time at a second home on an island paradise. While they have accomplished these goals taking several trips and cruises each year, they listened when opportunity came knocking once again. They were able to parlay their business experience into a "results based" consulting contract which is now generating over $500,000 a year in fees. So much for "retirement"!

But the real problem is the difficulty of putting enough money away for the golden years when Uncle Sam has his hand out for half the loaf every April 15th!

To create tax relief, we examined a dozen or so alternatives strategies ranging from exotic offshore trusts to the mundane. Under the old law, using a "defined contribution" plan, they would have been able to salt away about $70,000 a year. Not bad, but more of a Band-Aid to their tax hemorrhaging, leaving over $400,000 of income unsheltered each year. However, after examining cash flow needs and long-term objectives, it was clear a "defined benefit" pension plan with a first year deduction of $180,000 offered the greatest tax saving with the least amount of aggravation, risk and uncertainty.

Even though the plan wasn't set up until December, we were able to take a deduction for the entire year of 2001.

Better yet, because of even more tax changes that kick into effect this year, the deduction for 2002 and each year thereafter for the next 5 years is an even sweeter $200,000 per year!

There was nothing unique about Will & Beth. These types of saving are available for most entrepreneurs with a wide range of income and ages.

Cost Benefit Analysis:
It doesn't take a Ph.D. in Financial Physics to conclude Will & Beth are looking at a savings of about $450,000 or more over the next 5 years in personal income taxes alone! But don't forget, we've also put a "tax wrapper" around the investment portfolio allowing it to compound tax-free until it's needed. Then of course, Will & Beth will pay ordinary income taxes, but hopefully at much lower marginal rates. We estimate the "tax wrapper" savings to be about $12,500 per year for every $500,000 of plan assets or about $60,000 in this example. This gives us a combined tax savings of at least $500,000 and likely more!

So what does it cost to work this magic? Surprisingly, the design and implementation costs are quite modest, but you need a team of experts. Consulting fees including customizing the plan to your personal business situation as well as including actuarial calculations should run you less than $3,000. Once you're comfortable with design and the "do's and don'ts", then you'll need "plan documents" drafted, which should cost from $3,500 to $7,500. Sometimes lower cost "prototype" documents are sufficient. Don't be penny wise and pound foolish here! In many cases, custom documents are well worth the extra expense to provide maximum flexibility and protection down the road. Finally, you'll need a " plan administrator" to handle the paper work and IRS filings. A small plan should cost under $2,000 per year to administer. Again, this is not an area for a do-it-yourselfer.

So for total "all in" expenses of about $10,000 upfront or $20,000 spread over 5 years, Will & Beth will realize tax savings of about $500,000. That's what we call a super return on your investment!

 

Common questions & Caveats
"Can I have both a Defined Benefit Plan and a Defined Contribution Plan at the same time?"

The answer and "yes" and recent changes in the laws make this both more feasible and attractive by greatly reducing the "offsets" in the amount you can take a deduction for.

 

"When does it start making sense to look at a Defined Benefit Plan?"

Our experience has been that "Power Earners" with few or no employees are the best fit. As a rule of thumb, if you want to put away over $50,000 annually for the next 5 years, the option is viable. Otherwise consider a Defined Contribution plan.

 

"Am I too old to set up a DB Plan?"

The answer is "no!" DB Plans can be great to set up large contributions for people in their 60's or 70's. In fact a person aged 64 setting up a plan with a normal retirement of age 65, could take a tax deductible contribution of as much as $185,000 this year, a $65,750 increase over the old law.

 

"Will a DB Plan cost to much if I have to provide for other employees?"

Not necessarily. While you still must provide an equivalent benefit to all other "full time employees," the increase in the deductions has shifted the balance back in the direction of the Power Earner. Frequently this problem is not as great as initially perceived and can be structured with careful planning.

Take Bob for example, a much sought after computer design consultant, who set up his own firm last year generating over $3 million of revenue and $400,000 of personal income. Obviously the large deductions generated by a Defined Benefit Plan would be very attractive to Bob, but not if he had to pay similar benefits to the 25 programmers that work on his projects. By taking careful steps to make sure Tom's programmers met the requirement to be classified as " independent contractors' and not full time employees, Tom was able to set up a single employee plan and capture a tax deduction of over $160,000 this year. In 5 years Tom's DB plan should have over $750,000 put away for his retirement. As for paying for "other employees," Bob's answer, "What other employees?"

It's ironic that our country, founded on principles of self reliance, has historically put so many barriers in front of people trying to save for their own retirement. The changes in the tax law are welcome relief that any "Power Earner" needs to give a good hard analytical look at. For best results, this doesn't mean web-based do-it-yourself analysis. A good team of professionals is necessary to determine whether this strategy is viable for you.

For more information contact:

Barry Strudwick
Strudwick Wealth Strategies
12 East Eager Street
Baltimore, MD 21202
(410) 727-6444
Offshoreshield@noload.com

Have a question about wealth creation or preservation? E-mail us at invest@noload.com or call (410) 727-6444. Barry Strudwick can be heard each Sunday night at 4:00PM on WYPR 88.1 FM (formerly WJHU).

If you need assistance with these or other strategies, please contact: Strudwick Wealth Strategies "Innovation Equals Opportunity" (410) 727-6444 invest@noload.com If you would like to receive our newsletters, please e-mail me back that you would like to join our e-mail community.

 

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