By Mike Weintraub
When considering deductible retirement plans, many business owners and CPAs only think about 401(k) and Simplified Employee Pension (SEP) plans. But there's another option on the table they should be considering -- defined benefit/cash balance retirement plans.
Why? The most an employer can contribute to a 401(k) or SEP is the lesser of 25% of compensation or $55,000 ($61,000 for those 50 and over). While fine for some small businesses and professional groups, the recent Tax Cuts and Jobs Act of 2017 (TCJA) means that many small to medium-sized business owners are now paying less in taxes and have more than that amount to save for retirement.
This is where a well-designed cash balance plan combined with a 401(k) plan comes into play. It can provide deductions of $100,000, $150,000, $200,000, and more, for highly compensated employees, with smaller amounts to non-highly compensated employees.
How a Cash Balance Plan Works
Remember the old-school defined-benefit plans our grandfathers had back in the 1950s, working for companies such as General Motors? A cash balance plan is similar, but has a 401(k)-like twist to it.
Traditional pension plans promise participants a certain benefit at retirement, such as 50% of their final monthly paycheck paid to them for as long as they live. A cash balance plan also provides a promised benefit but in an account that looks like the lump sum balance in a 401(k) account, rather than as a monthly income stream.
The closer one is to retirement, the more the employer can sock away for the employee on a deductible basis without that amount being reportable as compensation to the employee. A 60-year-old employee who wants to retire at age 66, for example, can have more than $200,000 as a tax-deductible contribution -- a pretty good deal thanks to the recent tax reform legislation. The money would be taxable when paid out in retirement, but tax brackets may be lower then.
Benefits of Cash Balance Plans
The workforce is aging. Many employees don't even begin to start thinking about retirement savings until their late 30s and early 40s. Some don't get serious about doing anything until their mid-to-late 40s or even into their 50s.
By then it may be too late to fully fund a 401(k) plan to get the retirement outcome a highly compensated person wants. But the higher deductible limits allowed under a cash balance plan, combined with tax deductible dollars and tax deferred growth can turbocharge the plan and help reach the desired retirement outcome on time.
Who Should Use Them
The most significant cash balance plan action is taking place at small- to medium-sized employers. There have been increasing levels of interest from the technology sector, retail industry, and manufacturing companies, but the greatest interest comes from professional service firms. Doctors, lawyers, and accountants are typically highly compensated and are eager to save when the numbers for them are big, yet the contribution is deductible.
The growing gig economy of entrepreneurial consultants, professionals, and others can also benefit from these plans. Just one, two, or three employees in a combination 401(k)/cash balance plan can help employees and owners get larger deductions and more cash for their retirement.
Regardless of industry, the best outcomes are generally for plans covering those over age 50.
Here's an example of how a 401(k) combined with a cash balance plan worked for a small professional firm with 23 employees including three owners. The objective was to provide the three owners with deductible contributions of varying amounts chosen by each owner. Owners one and two wanted to contribute $100,000, while owner three wanted to contribute just $50,000 to the cash balance plan. They also wanted to make company contributions of as little as possible to the other 20 employees. Every employee could defer as much as they wanted (up to the limits allowed) to the 401(k) plan, which was a safe harbor plan. This meant the company would contribute 3% of each eligible employee's pay, which allowed any highly compensated employee to make the maximum contribution to the 401(k) plan. As a result, almost 80% of the company contributions went to the three owners, while the company took a tax deduction of more than $500,000.
Setting up a Cash Balance Plan
How do I set up a plan? What does it typically cost, and what should make me think twice about doing it?
An actuary must design and certify the funding of the plan every year. A third-party administrator (TPA) generally prepares the plan document and provides all the ministerial services for the plan on an annual basis. There may also be investment advisory and brokerage fees. Expect to pay anywhere from $2,000 to $5,000 to set up the plan, with additional annual fees of $1,500 to many thousands of dollars depending on the number of participants.
The government also wants the plan to be permanent. An attorney who has a gigantic fee this year, or a real estate agent who has a career best commission that results in a windfall of taxable income that is unlikely to happen again, and wants to use a cash balance plan to reduce what would otherwise be a big income tax, shouldn't use this plan for that sort of event without thinking through how to handle contributions in future years.
Plan sponsors should think about doing similar contributions to the plan for a number of years. If everything stays the same, employee population and their compensation, investment returns for the plan, etc., then the contribution amounts will be about the same each year.
Is it right for you?
The TCJA has given many business owners more cash to invest in things like retirement plans. If you're looking for a tax-advantaged way to set aside some of the tax dollars you now have as a result of the TCJA, it might be a good time to look closely at how a cash balance retirement plan can work for you.
About the author: Mike Weintraub is president of the Retirement Plans Division at Relation Insurance Services. Relation Insurance Services offers risk-management and benefits-consulting services through its family of brands across the U.S.