Here’s a tax-related retirement plan dynamic that often gets overlooked. When considering whether to set up a retirement plan, most business owners tend to focus on the economic impact of deferring income. However, there is a very real immediate tax savings that happens as well.
For example, consider a business owner who has the choice between taking $500,000 in compensation, or taking $300,000 in compensation and contributing $200,000 to a defined benefit pension plan. Income tax implications aside, if she contributes the $200,000 to the DB plan rather than taking that as compensation, she avoids paying payroll tax on that amount, either as the employer or as the employee. Only the Medicare portion of the FICA rate gets applied at these high compensation levels, but that’s still 1.45% times two (employer and employee portions). She ends up with a true tax savings of $200,000 x 1.45% x 2 = $5,800. If her final compensation is lower and the Social Security portion of the FICA rate comes into play, or if state and local payroll taxes apply (as several currently do here in the Portland area), the tax savings is even more.
Again, this isn’t a subjective calculation that reflects assumptions about future asset returns or tax rates; these are concrete, immediate, demonstrable savings.