As you approach retirement with substantial savings in IRAs, 401(k)s, and other investments, you may wonder whether it’s still beneficial to set up a defined benefit plan. This is a common question for high-income earners who anticipate having a significant income during retirement.
Even if you expect to continue earning a high-income post-retirement, there are several factors to consider when determining whether a defined benefit plan is the right choice for you.
This article summarizes a discussion we had on a recent podcast. We often encounter people with a high current income, but they also expect a substantially high income in retirement.
So they wonder whether paying the tax now makes sense and not having to worry about it later. You can certainly do some sophisticated analysis on this, but future tax rates will also impact the analysis. Nobody has a crystal ball.
Below will spell out the key points discussed in the podcast, but feel free to watch the podcast on our YouTube channel:
Understanding High Income in Retirement
“High income” in retirement generally refers to those who have accumulated substantial retirement savings or expect ongoing income through investments, rental properties, or continued work. For instance, if you’ve stored away millions in IRAs and 401(k)s and anticipate receiving high required minimum distributions (RMDs), you may continue to fall into a higher tax bracket even in your retirement years.
High-income retirees face unique challenges, particularly when it comes to managing taxes. This leads to the central question: is it still worth setting up a defined benefit plan when your future retirement income will be substantial?.
Tax Considerations for High-Income Retirees
Taxes are one of the biggest concerns for high-income retirees. Even though you’re no longer working, RMDs from tax-deferred retirement accounts like IRAs and 401(k)s can push you into higher tax brackets. The IRS requires you to start taking RMDs from your accounts at age 73, and for those with large retirement balances, these distributions can generate significant taxable income.
In addition, there is ongoing uncertainty about future tax rates. Many financial experts believe that taxes are likely to rise, especially for high-income earners, meaning that future RMDs may be taxed at higher rates.
How Defined Benefit Plans Help with High Taxes
A defined benefit plan offers significant tax advantages during your working years, especially when your income is high. The key benefit of a DB plan is that it allows you to defer taxes on income you earn today, reducing your current taxable income.
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For example, if you’re earning $500,000 or more annually, contributions to a DB plan could lower your taxable income, providing immediate tax savings. The funds contributed to the plan grow tax-deferred, meaning you won’t pay taxes on the gains until you start withdrawing money in retirement.
Long-Term Tax Deferral vs. Paying Taxes Now
One of the core considerations when deciding whether to set up a DB plan is whether you’d prefer to pay taxes now or defer them until retirement.
- Deferring Taxes: If you’re currently in a high tax bracket, deferring taxes through a DB plan allows you to take advantage of the tax deductions today when they are most valuable. This strategy makes the most sense if you expect your income to be lower in retirement.
- Paying Taxes Now: However, if you anticipate that your retirement income will remain high—due to significant RMDs, pensions, or ongoing earnings—you may prefer to pay taxes now and avoid being taxed at high rates in retirement.
Example: The High-Income Earner Facing RMDs
Imagine an individual with several million dollars stored in IRAs and 401(k)s. As retirement approaches, they face a significant tax burden due to future RMDs. Even though they’re no longer earning a salary, their RMDs alone could push them into a higher tax bracket. Adding a DB plan to this scenario might not provide enough of a long-term tax benefit if the individual expects to remain in a high-income bracket during retirement.
High RMDs: A Challenge for High-Income Retirees
The challenge with RMDs is that they are non-negotiable—you must take them, and they are taxed as ordinary income. For someone with millions in retirement savings, RMDs can significantly increase taxable income, creating a tax burden even in retirement. This is where proper planning becomes crucial.
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Strategies such as Roth conversions (where you pay taxes on retirement savings now rather than later) or taking advantage of tax-friendly locations (moving to states with no income tax) can mitigate this impact.
Planning for Future Tax Rates
Many financial experts believe that tax rates for high-income earners are likely to rise in the future. If you are in the top income bracket now and expect to remain there in retirement, it’s essential to factor in potential tax increases.
In this context, setting up a defined benefit plan to defer income could be less advantageous if your future tax rate is likely to be as high—or higher—than it is today. However, the time value of money still makes tax deferral strategies worthwhile in many cases, especially if you’re uncertain about future income levels.
How State Taxes Influence Your Decision
Another factor to consider is state income taxes. Where you live in retirement can greatly impact your overall tax burden. For example, if you’re currently living in a state with high income taxes like California, but plan to retire in a tax-free state like Florida or Nevada, deferring taxes until retirement could save you a significant amount in state taxes.
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On the other hand, if you plan to stay in a high-tax state, paying taxes now might reduce your overall long-term tax burden.
Is a Cash Balance or Defined Benefit Plan Right For You?
The Time Value of Money in Retirement Planning
One reason many financial advisors recommend setting up a DB plan—even if you expect to have high income in retirement—is the time value of money. The concept is simple: a dollar saved today is worth more than a dollar saved in the future because it has more time to grow. By deferring taxes now, you can allow your investments to compound over time, increasing your retirement savings substantially.
For example, if you defer $100,000 in income today and invest it in a tax-deferred plan, that amount could grow significantly by the time you retire. This growth can more than offset the future tax burden, especially if you’re able to lower your tax rate through strategic withdrawals or moving to a lower-tax state.
Will Having More Money Help You Sleep Better?
One important, yet often overlooked, consideration is peace of mind. Many high-income earners feel more secure knowing they have additional funds set aside for retirement, even if they already have significant savings.
For instance, even someone with $10 million in retirement savings may sleep better knowing they have an extra $1 million in a DB plan. The psychological benefit of knowing you’re financially secure can outweigh the potential tax drawbacks.
It’s common for people to feel uneasy about retirement, even when they have substantial savings. The fear of outliving their money, unexpected healthcare costs, or market volatility keeps many retirees up at night. For these individuals, having more money in tax-deferred accounts—even with the prospect of future taxes—offers peace of mind.
Weighing the Pros and Cons of a DB Plan for High-Income Retirees
For some high-income retirees, a DB plan isn’t a “home run.” It provides tax deferral and increased retirement savings, but it may not offer a dramatic long-term benefit if you expect to remain in a high tax bracket. However, for many, the extra savings, peace of mind, and potential to reduce taxable income today still make it a valuable strategy.
Life is unpredictable, and financial situations can change. Divorce, remarriage, or other unexpected life events can alter your financial landscape. Setting up a DB plan today provides you with more options in the future, even if your financial situation changes. It’s important to account for uncertainties and the possibility that your retirement income or family situation could look different than you anticipate.
Final Thoughts
In conclusion, whether setting up a defined benefit plan makes sense if you expect to have high income in retirement depends on several factors, including your current tax bracket, expected retirement income, and long-term financial goals. While future tax rates are uncertain, deferring taxes now may still provide significant advantages, especially if you plan to retire in a lower-tax state or expect life changes.
Ultimately, it comes down to your personal comfort—whether you prefer to pay taxes now and move forward or take advantage of the time value of money and build additional retirement savings.
