With interest rates at or near all-time lows, saving for retirement is more critical than ever. But it is very difficult for investors to get a meaningful return on their money at acceptable levels of risk. Today's savers need every tax break they can get to accumulate retirement wealth. And then they need to take steps to turn that wealth into a steady, reliable stream of income that they will not outlive.
Defined Benefit vs. Defined Contribution
When most people refer to pensions, they are referring to traditional defined benefit plans, in which the retiree receives a set amount of income each month. The plan defines the benefit. It's up to the employer to provide enough funding to support that level of income over the lifetime of the retiree. Technically, 401(k) plans, SIMPLE IRAs, SEP IRAs and 403(b) plans are pension plans as well. With these plans, however, there are no guarantees on the income. The income is a function of contributions. The employee can define what contributions will be made to the plan, within certain limits prescribed by law. Small business owners, self-employed individuals, and owners or employees of a corporation can create a defined benefit pension plan on their own.
Lifetime Income Annuity
The term "annuity" refers to a stream of income, which can be annual or monthly. The term also refers to contracts with insurance companies: You send money, or "premiums," to an insurance company. In return, it guarantees an income at some point in the future. The simplest annuity product is the lifetime income annuity. This product guarantees you a stream of income for as long as you live. You can also elect to base the annuity on two lifetimes. For small business owners and individual retirees, the lifetime income annuity works as a tool to maximize the amount of monthly income they will receive on a guaranteed basis (However, the guarantee is only as strong as the insurance company.) Funding a lifetime income annuity of sufficient size at retirement age, on a guaranteed basis, is generally the objective of a pension plan.
Funding the Pension
You can hold the assets earmarked to fund your retirement annuity inside or outside of a retirement account. To create a true pension plan, however, you would generally fund it by creating a Section 412(i) plan. These pension plans must be funded with either life insurance or annuities. Contributions are generally deductible to the business, and assets within these plans grow tax deferred. In the case of cash value life insurance, you can actually access the money tax-free. These plans are best suited for highly compensated owners or employees with reliable, disposable income that can be committed to the pension every year.
You can also execute a similar strategy by creating a solo 401(k) plan or SEP plan for yourself and your business. However, the IRS restricts the amount you can use to fund these accounts. The 412(i) plans may work well for those who have maximized their available contributions to 401(k)s, SEPs, SIMPLEs and IRAs or who earn too much money to qualify. While you do get the benefit of tax deferral with these plans, you give up the chance for favorable treatment of long-term capital gains, which are lower than income tax rates. Consult a qualified tax adviser for information on the tax-planning aspects of pension plans.
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