As of late, most financial advice regarding retirement options has been geared toward company employees. While that covers the largest demographic of working individuals, many Americans do not fall into this category.
More than 12% of American workers are self-employed. And the number of these business owners, independent contractors and freelancers continues to grow. Many would argue that millions are not receiving sufficient guidance on retirement planning.
On top of that, the self-employed do not always receive a steady annual income, or pay consistent taxes, and have limited options for retirement-planning products such as a 401(k) plan. This can affect how they evaluate retirement income needs, taxes, appropriate withdrawal rates and suitable planning tools.
When considering options, many self-employed who want to enhance their retirement nest eggs should consider the defined-benefit plan.
While many pension plans — and the days of the gold watch — have gone the way of the dinosaur, they still are a viable option for self-employed workers looking to sock away savings for retirement.
For a self-employed individual 45 or older who wants to maximize tax-deductible contributions to a qualified plan, an ideal design would be a cash balance, or a combination cash balance and 401(k) plan. (Cash balance plans are defined-benefit plans.)
These plans can fund an annual benefit of up to $195,000 a year, to be paid at retirement age. The closer you are to retirement, the greater the contribution. In other words, if the time horizon to retirement is short, the individual must put enough away in contributions to pay out the benefit.
IN CONTROL
One of the chief advantages of a defined-benefit plan is the flexibility it offers. The investment risk and
portfolio management are exclusively under the control of the company or self-employed worker. Also, where most retirement fund payouts are determined by the invested funds' returns, defined-benefit plans are determined by length of employment, salary history, etc., all of which is controlled by the self-employed individual.
Another significant advantage is that the defined-benefit plan offers the self-employed person whose business has struggled, but suddenly finds success, the ability to catch up in peak earning years. In other words, DB plans display a J-shaped accrual pattern; significant benefits are possible in a relatively short period of time. Also, the amount a self-employed pre-retiree can contribute to a defined-benefit plan typically is much higher than allowed contributions to an employer's defined-contribution plan.
Another benefit to this retirement fund is the large tax savings it provides. Generally, contributions made to a defined-benefit plan are 100% tax-deductible — within any IRS limits, of course.
Earnings amassed from contributions also are allowed to grow tax-deferred, which is another way to take advantage of the favorable accrual pattern mentioned earlier.
As with any retirement vehicle, it's important to keep in mind that this option may not work for all self-employed individuals. Those who utilize a defined-benefit plan need to take extra precautions when evaluating their retirement income needs. For example, they contribute all the money — there is no “company match.” Also, keep in mind that the flexibility discussed earlier comes at its own cost.
A defined-benefit plan clearly is favorable for many self-employed individuals looking to catch up on their retirement savings.
The best advice for anyone looking to create such a plan would be to define their investment risk tolerance, set realistic salary and retirement date goals, and educate themselves on the
investment vehicles available through a defined-benefit plan.
David Peterson, an attorney and certified financial planner, is the president of Peak Capital Investment Services Inc.
