What if you could get an extra $3 million into retirement?
What if you could get a tax deduction for the contribution? Take a look below:
This is a little-known retirement structure called a cash balance pension plan. It is often referred to as the #1 retirement strategy for business owners.
But before you write a check for $3 million (more about this later), you need to understand a few key details. So let’s jump in.2021 Quick Navigation
- What is a cash balance pension plan?
- How does a cash balance plan work?
- How much can I contribute to a plan?
- Plan advantages
- Are there disadvantages?
- What companies are best suited?
- Tell me about my investment options?
- How can I customize a plan?
- Are there any tips or strategies I should be aware of?
- Can plans be combined with other retirement structures?
- What are the risks I should consider?
- Can you show me an example?
- What if I want to terminate a plan?
- Bottom line
What is a cash balance pension plan?
A cash balance pension plan is special type of retirement structure that allows business owners to make large tax deductible retirement contributions. You can think of it as a 401k plan on steroids. In fact, annual contributions can be as high as $300,000 or more.
In the right situation, they can be a home run. There just are not that many structures that you can contribute 6 figures and get a full tax deduction.
Many business owners are searching for tax deferral strategies and a way to accelerate their retirement savings. These plans address these two issues.
How does it work?
So let’s start with understanding some retirement basics. Retirement plans are classified into two main categories: defined benefit plans and defined contribution plans.
Defined benefit plans look to generate a specific benefit at retirement. However, defined contribution plans work a little differently. They specify a maximum contribution limit up front.
You know how a 401k establishes maximum annual contributions? That’s because it falls under the defined contribution category. In contrast, a cash balance plan falls under the define benefit plan category.
A 401k has an annual employee maximum contribution of $19,500 (for calendar year 2021). Once you contribute this amount, the account can grow to $1 million or it could go to zero. For plan purposes, it doesn’t matter.
The defined benefit plan
But a cash balance plan doesn’t have that same annual limit like the 401k plan does. It is actually trying to contribute enough money so that you have a specific account balance when you retire (typically at age 62).
How much money you have when you retire is dependent on a few things. But most importantly, it is how much compensation you were paid over the years.
Assuming you meet the criteria, you can have approximately $3 million when you retire. You get the point. It’s a nice nest egg.
So how do the contributions work?
So here is what’s special about these plans. All things being equal, the older you get the more you can contribute and the larger the tax deductions. As a result, allowable contributions will increase with age.Looking for more information on cash balance plans? Take a look at our ultimate guide to cash balance plans. Discover our favorite strategies!
Here’s how it works. Let’s assume there are two employees who both make $50,000 a year. One employee is 35 years old and the other is 55 years old. In theory, they both should have the same retirement benefit at age 62.
Only a small contribution is required because the 35 year old has many years until retirement. But the 55 year old just has 7 years to hit the plan retirement age. As such, you can make a much larger contribution.
So therein lies the beauty of the plan. Most high income self-employed people tend to get more serious about retirement (and have more money) when they are in their mid-forties and fifties. Annual contributions in the age range can often exceed $100,000 annually.
How much can I contribute?
Basically all retirement vehicles have some form of contribution limit. Cash balance plans are really no different.
As stated previously, contribution limits are highly dependent upon employee age. The table below is meant to give you a general idea of contribution limit based on age.
But please realize that these are estimated amounts and final numbers are determined by an actuary. So use these as a guideline:
|Age||Max Annual Contribution|
Here’s a tip to get a bit more into a plan. A new plan (one that is not a conversion of an existing defined benefit plan) can grant “past” or “prior” service in the form of an opening cash balance credit. This allows for a larger plan contribution in year one.
These plans have a lot of advantages. So let’s take a look at them:
- They are “qualified” plans. This means that they qualify for tax deferral status.
- They are not subject to the traditional contribution limits associated with 401k plans.
- Qualified plans offer creditor protection. This protection comes under ERISA. This is especially handy when subject to bankruptcy and lawsuits.
- They work great for sole proprietors, S-corps and C-corps. It also will work similarly for a partnership.
- They can be combined with other retirement program structures, such as a 401k, profit sharing plan or even an IRA.
- A solo cash balance pension plan or one person plan can use the Mega Backdoor Roth.
- They allow for portability. If an employee leaves the company, he or she can take the vested assets to another plan or simply roll it into an IRA.
- Did I mention that contributions are tax deductible?
Are there disadvantages?
But those large contributions come with a price. These plans are more complex and more expensive to administer. An actuary has to complete an annual certification. And make sure that your financial planner and CPA are on board. Most don’t understand how they work.
Like any plan, there are some disadvantages. Let go through them:
- The plans are permanent and contributions are not elective like defined contribution plans. You should plan on keeping them for at least 3 years. You can terminate for good cause.
- An actuary must review and certify plans each year. This is to ensure that funding is adequate to pay future retirement obligations.
- They are a more expensive program to administer. Most plans will run $2,000 or more to administer.
- The plans often have rules and restrictions on the lump sum payment options.
Business owners do enjoy some flexibility under a cash balance plan. The owner has some control over which employees they can contribute for and how much (subject to IRS non-discrimination rules).
What companies are best suited?
Now that you understand the basics, let’s look closely at the companies that are great candidates for these plans. As a general rule, a company should have the following qualities:
- Consistent cash flows and high profits.
- High marginal federal and state tax rates.
- The goal of aggressively accumulating retirement savings.
- The desire to get large tax deductions.
- The motivation to “catch-up” on retirement planning.
The ability to contribute a larger amount per year based on each individual’s age, make a cash balance defined benefit plan very attractive for any small business owner.
But be careful. Many small business owners want to re-invest as much of the business profit back into the company.
Who else could benefit?
Others who may benefit from plans are:
- Companies with large income streams and the ability to contribute the minimums to a cash balance plan.
- Companies who want to combine retirement structures and seek bankruptcy and creditor protection.
- Companies wanting to provide an attractive employee benefit to motivate staff who play a key role in the company.
Tell me about my investment options?
Many people think that the third-party administrator who sets up the plan will also manage the plan assets. Alternatively, they often believe that they must contribute their funds into a specific investment vehicle. This is far from the truth.
Most companies will open up an account with their financial advisor or a traditional discount broker like Charles Schwab, Fidelity, Etrade or Vanguard. We have relationships with all the large custodians to help expedite the plan set-up process.
These plans do not have to have a “special” account. The reality is that the plan establishes a trust. This trust is similar to what you would have with a 401k plan.
Plans can invest in stocks, bonds and mutual funds. This is similar to a 401(k) plan. Employees cannot chose individual assets as all funds are in a pooled account.
How can I customize a plan?
The good news is that there is some flexibility in plan design rules. These plans can be customized to slant in favor of the business owner.
The plan administrator (or TPA) can run multiple illustrations to compare different plan options. For example, the company can contribute different amounts for different participants.
Funding reductions are not allowed when employees reach 1,000 service hours. Plans can be terminated or frozen. But only before employees reach 1,000 hours. This is the case only if the company does not want to make a contribution for the current year.
Are there any tips or strategies I should be aware of?
So how can you make the cash balance plan work for you? Consider the following tips as a guide:
- Set a service requirement. Limit the number of employees you set up a cash balance plan for by requiring a specific amount of service. For example, a 1-year service requirement can minimize setting up cash balance accounts for employees with a high turnover rate.
- Hire part-time employees. While you must include a specific number of employees in the plan, not everyone needs to be a part of it. Make some of your staff part-time employees and you can automatically exclude them from the plan.
- Hire young employees. The cash balance plan also has an age limit. You may exclude anyone under the age of 21.
- Hire your spouse. With your spouse as an employee, you can take advantage of tax-deferred earnings as well as paying him or her a portion of the profit sharing.
- Increase your compensation. If you run an S corporation, you can increase your earnings, as long as the IRS considers the wages reasonable for your industry. Discuss this with your CPA or tax advisor before moving forward. Your higher earnings mean more profit sharing in your name.
- Maximize vesting rules. You can extend the 100% vesting rule to 3 years. This means plan participants don’t ‘own’ any of the money until they work for you for at least 3 years. After the 3-year mark, they are 100% vested. But before that they are 0% vested in the cash benefit plan.
- Include life insurance. You can utilize the tax benefits of using plan dollars to pay the life insurance premiums of your employees. You use tax-deductible dollars to pay the program premiums.
- Pay more than the target. During good financial years, consider paying more than the plan requirement. You get the tax deductions and lower your financial responsibility for contributions in future years.
Can plans be combined with other retirement structures?
As an employer, you have the option to combine a 401K profit-sharing plan with the cash balance plan. As an owner, you can decide how much you want to contribute based on your company’s profits at year-end. You can contribute up to $19,500 as an employee deferral in 2021.
If you set up your account as a safe harbor plan, you’ll need to make a contribution each year. It doesn’t matter what your profits are – you must contribute the amount stated, typically around 4%.
Fortunately, you can deduct the safe harbor amount from the profit-sharing amount, reducing the amount you must contribute.
What are the risks I should consider?
The company should always discuss the pros and cons of any new retirement plan up front. Since each plan type has different features, it is helpful for the advisor or benefit consultant to compare and contrast the most important features between plans.
Financial and legal risks are a prime consideration, and these can be managed by ensuring compliance tests and government filings are completed accurately and timely.
If assets return more than expected, the employer contribution will decrease (all other assumptions being satisfied). On the other hand, poor returns require increasing employer contributions.
Can you show me an example?
Now that you understand the basics, let’s take a look at a real life example. This plan is rather straightforward. It is for a small law firm.
Small companies who operate as sole proprietorships (and have no employees) are certainly able to set up cash balance plans. We typically refer to these plans as solo or one person plans.
The business owner can establish a plan and provide funding for just himself or herself and may also be able to contribute for a spouse that works at the company.
In this example, the husband is the attorney and the wife performs administrative services. The plan was structured as follows:
The above plan suits him and his wife just fine. They are able to get $240,500 into the combined 401k profit sharing plan and the cash balance plan.
Please note that the basic 401k plan (with profit sharing) allows a profit sharing maximum contribution of 25%. But when the plan is combined with a cash balance plan it is limited to only 6% (subject to other rules).
What if I want to terminate the plan?
A cash balance pension plan meets the definition of a defined benefit plan. The employer bears the cost of contributing to the pension.
At retirement, the employee may choose to accept the vested benefit as a lump sum distribution. The employee may also roll the plan into an IRA to allow the monies to continue to accrue interest.
Should an employee leave the company before retiring, he or she may request a distribution of the vested account balance. Alternatively, they may roll the entire fund into an IRA.
Under a traditional pension plan, employees do not have the option to roll funds over. Instead, they will receive a reduced annuity or a lump sum when they finally retire.
Cash balance pension plans are becoming increasingly popular and they are great plans for the self-employed. With many 2021 business owners looking for significant tax deductions, asset protection, and the ability to make sizable retirement contributions, cash balance plans make great options.
Through pension reforms over the years, the plans have become more flexible and offer streamlined administration. Make sure you consider them in your retirement arsenal. Hopefully, this cash balance plan guide has helped you understand the basics.