Pension Plans Being Used as Tax Shelters

Pensions plans are retirement plans that involve employers setting aside contributions for workers’ future financial benefit. The earnings on the investment funds help to earn income for the worker once they are retired and are in a lower-earning bracket; this is the traditional way that pension plans are established and used.

Currently, pension plans are being used in a different way by high-earning individuals wanting to pay less taxes, and it begs the question as to whether or not this is an acceptable strategy. Pensions are now being used by doctors and lawyers to hide large quantities of their yearly income, sometimes in excess of $300,000. In doing so, high-earning individuals attempt to outwit the income limits imposed by Congress.

The Treasury Department’s Response

The Treasury Department has begun to question tactics where wealthy individuals and firms bend tax, pension plan, and pass-through entity regulations to their advantage. In response, the Department has recently suggested establishing regulations regarding who is eligible for the 20-percent deduction, which decreases the top tax rate from 37 to 30 percent. Tax-evasion strategies such as the ‘crack and pack’ where business owners divide their firms into separate entities to decrease their tax bills is just the kind of maneuver being considered abusive and called into question by the Treasury Department.

Tax reforms have made retirement plans even more beneficial, as wealthy individuals are looking for more ways to lower their tax bills. Firms specializing in defined-benefit plans (retirement plans) are openly marketing pensions as a strategy for professionals to avoid the new tax rules. Traditionally, pension plans are set up during the last few months of the tax year so that individuals can maximize the tax benefits, but the recent changes have seen professionals setting up new pensions, referred to as ‘cash balance plans’ while also increasing existing plan contributions early in the year and throughout.

Large medical groups and law firms are offering cash-balance plans to their high-earning partners to decrease their tax bills. These professionals increase their contributions to existing plans to try and capitalize on the pass-through deduction. The largest potential, however, is for the many smaller businesses that don’t have the same contributions.

Low-Earning Individuals

Lower-Paid employees can also benefit from the new uses for pension plans. As retirement plans are subject to regulations, such as non-discrimination rules, business owners are obligated to distribute retirement wealth throughout their employees, including lower- and middle-earning individuals. The distribution rules are dependent on the workforce’s age and income levels, but most often, for low- and middle-earning individuals, these plans would equate to almost 8 percent of their total salary. That is why cash-balance plans are too costly for large businesses with high percentages of low-earning individuals; in small businesses, however, the financial benefit generally goes to the owners, rather than the employees.

Businesses and Cash-Balance Plans

When it comes to businesses and cash-balance plans, the rules depend on the age and income levels in a workforce. Typically, setting up a cash-balance retirement plan for the owner of a business will demand a profit-sharing percentage for middle- and lower-class employees. A cash-balance plan can be too expensive, therefore, for larger businesses with many low earners. What this reveals is that cash-balance plans are not the answer for all businesses. Business owners have to engage in some serious thought and strategizing before deciding to fund long-term pension contributions.

While rich professionals, like doctors and lawyers, are using pension plans as a means to the end of dodging taxes, the Treasury Department proposes regulations and income limits to counteract these tax-dodging tactics viewed as abusive.