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How a Cash-Balance Retirement Plan Helps Business Owners

Adviser Matt Stratman writes that cash-balance plans have been growing in popularity. This little-known strategy can cut taxes while paying business owners at the same time.

By Matt Stratman

The federal government cut taxes in 2017, but chances are, if you are a highly paid entrepreneur or business owner, you still feel like there is a large percentage of your income going to taxes.

With combined federal and state income tax rates as high as 45%, many business owners are searching for any way possible to lower their tax burden. Fortunately, there is a little-known strategy to massively reduce your taxes while paying yourself at the same time. A cash balance defined-benefit (DB) plan is a way to create your own retirement pension in a tax-efficient manner.

What is a Cash Balance Plan?

Cash balance plans are like traditional DB pension plans and share a few key similarities to 401(k) defined-contribution (DC) plans. Like a traditional DB plan, the benefits are calculated using formulas and participants are promised a certain benefit at retirement. Often the formulas are based on a percentage of the employee’s earnings -- and a rate of interest on that contribution that will provide a predetermined amount at retirement, usually in the form of a lump sum.

The crediting rate is guaranteed by the employer and is independent of the plan’s investment performance. Because the company issues a guarantee, they may be required to purchase insurance from the Pension Benefit Guaranty Corporation (PBGC). However, professional service firms with 25 or fewer participants and plans that only cover the owner may be exempt from this requirement. PBGC coverage is added protection to ensure that the guarantees will be strong enough to cover the participants when they ultimately retire.

During accumulation, individual participants are not able to direct the investment of their account. Plan assets are pooled and invested. If the plan’s portfolio return is below the crediting rate, it can result in a plan that is underfunded. A return above the crediting rate results in a plan that is overfunded. At plan termination, any shortfall must be made up by the plan sponsor.

Alternatively, if there is excess, that amount would be subject to an excise tax. While it is nice to receive a high return on an investment portfolio, this could lead to lower future contribution limits since the current maximum lump sum benefit is $2.9 million. A low volatility portfolio with returns close to the crediting rate is often the best way to manage the investments.

Like a 401(k), each participant receives a statement and has an individual account with a hypothetical account value based on the crediting rate. These accounts are maintained by the plan actuary, who generates annual participant statements. At retirement, participants can take either an annuity based on their account balance or a lump sum which can then be rolled into an IRA or another employer's plan.

Powerful Tax-Deferral Strategy

Cash balance plans are qualified ERISA plans -- which means that contributions are treated as above-the-line tax deductible expenses. Above-the-line deductions are attractive because they reduce income dollar-for-dollar. Cash balance plans have generous contribution limits that increase with age. People 60 years and older can contribute well over $200,000 annually in pretax contributions. When the owner’s spouse is an employee of the company the contribution could potentially double to $400,000 or more.

To enhance the tax deduction an owner will often pair a cash balance with a DC plan to defer an even larger amount of income. Currently in 2020, 401(k) limits allow a business owner to contribute up to $57,000 plus $6,500 if they are over the age of 50. Establishing a cash balance plan alongside a 401(k) will give them a much higher combined contribution limit than with a 401(k) alone. At retirement, if the funds are rolled over, the balance can continue being invested and growing tax-deferred until the age when minimum distributions are required.

Give Retirement Savings a Boost

A cash-balance plan could be the ideal solution for many entrepreneurs and business owners with a short retirement time horizon who want to turbo-charge their retirement savings. There are several reasons why a high-income business owner may have underfunded their personal retirement account. Business ventures are often capital-intensive in the early years and professionals such as doctors and lawyers may have substantial payments going toward student loans immediately following graduation, for example.

For these reasons and more, many people find that a traditional IRA or 401(k) is not going to be enough. When focusing on retirement a cash-balance plan could be a perfect strategy for someone who has waited until later in their career to save. Because the contribution amounts allowed in cash-balance plans are age-dependent, older participants can accelerate their savings.

Accommodate Multiple Owners

These plans also can be customized to fit the distinct retirement strategies of multiple owners within a company. A company may have partners and owners of varying ages with different retirement time horizons. A cash-balance plan can be customized to allocate a different amount to each owner since they have different lengths until retirement. Since an individual statement is provided to each owner with a balance, they are good vehicles for keeping track of different contribution amounts for each owner. This makes it easy to understand what the benefit amount is for each individual owner when they reach retirement.

Before Beginning a Cash-Balance Plan

Companies considering cash-balance plans should be stable enough to meet an annual obligation. Contributions to these plans are not discretionary and must be funded annually until the plan is terminated. The plans can only be amended to increase or decrease the benefits and contributions for valid economic reasons. Carefully consider the company’s future obligations make sure you’re confident about its future stream of income to meet the needs of the plan.

As an ERISA plan, a cash-balance DB plan is subject to nondiscrimination testing and must provide benefits to all eligible employees, which means a cash-balance plan can be more expensive for a larger company.

If your company has a large staff, adding a cash-balance plan can still be a good idea, provided a design is done to ensure that the benefit justifies the cost. When a DB and DC plan are offered in tandem, these combo plans are tested together and the owner could potentially receive much larger total contributions with minimal increases to the contributions required on behalf of the other employees. When looking at both plans together, an actuary can consider both benefits for compliance testing. By awarding assets inside the 401(k) plan, the employer may elect to award lower cash-balance credits to employees.

The typical cash-balance plan will cost a little more than a typical 401(k) for a small business or entrepreneur. Cash-balance plans require an actuary to set up and administer the plan and this additional requirement comes at a cost. Typically, the set up will run between $2,000 and $4,000 with similar costs for annual administration. If the plan is more complex with several participants, the cost could be higher. In most cases the amount saved in taxes will justify the cost of administration.

Whether a cash-balance plan is the correct choice for you will depend on a variety of factors. Cash-balance plans have been growing in popularity due to the obvious advantages, but the pros must be weighed against any potential cons. When it comes to implementing a cash-balance plan, it’s a good idea to consult with a CPA to discuss how the contributions will affect your business from a tax standpoint. An experienced financial adviser will often work collaboratively with your CPA to determine how to properly structure the plan.

About the author: Matt Stratman is a financial adviser at Western International Securities. His focus is helping business owners and entrepreneurs who are planning for retirement. With a strong client-centered approach, he creates personalized investment strategies to help them reach their financial goals.