Bruce is a successful doctor who is 60 years old and married. He has two medical offices and a dedicated staff, and his income, including investment income, is $650,000 per year. Although he contributes the maximum amount permitted to his 401(k) plan, the actual amount of state and federal taxes that he paid was more than $250,000.
Recently, Bruce adopted a cash balance plan for his practice. This allows him to contribute more than $235,000 to his retirement plan and deduct this amount from his income. The new amount he pays in taxes is less than $140,000, giving him a whopping $110,000 in actual tax savings.
What Is a Cash Balance Plan?
Generally speaking, there are two types of company retirement plans: defined benefit plans and defined contribution plans. In a defined benefit plan, a specified annual retirement benefit (based on the employee’s salary) is provided for each employee. The type of defined benefit plan that most people are familiar with is the typical company pension plan.
In a defined contribution plan, the actual retirement benefit that the employee receives will depend not on the employee’s salary but rather on the contributions made to the plan plus investment gains and losses. The most common example of this type of plan is a 401(k) plan.
Although both of these traditional retirement plans offer the ability to put away money on a tax-deferred basis, they both have their limitations. With a defined benefit plan — such as a traditional company pension plan — there is only a stream of income paid out to the employee upon retirement. There is no “cash balance” that the employee is able to take and move should they desire to do so. On the other hand, a defined contribution plan such as a 401(k) plan has a cash balance for the employee to take upon retirement. However, the account balance is the responsibility of the employee, and annual contributions to 401(k) plans are significantly limited.
A cash balance plan eliminates these limitations. A cash balance plan is a hybrid plan that has elements of both. A cash balance plan is technically a defined benefit (pension) plan in that a series of annual lifetime payments is made available to the employee upon retirement. However, like a defined contribution plan such as a 401(k), a lump sum benefit in the cash balance plan is available for the employee to roll over to their individual retirement account.
Of even greater benefit to high-income earners such as Bruce is the fact that tax-deductible contributions to a cash balance plan are based on the owner’s and worker’s age and job classifications. Therefore, owners and workers who are close to retirement age (like Bruce at age 60) can contribute massive amounts of “above the line” or pretax money to the plan each year. Not only will this money grow tax-deferred, but the senior employee/owner also receives an enormous tax deduction annually.
Growing Popularity and Favorable IRS Rules
In September 2014, the IRS finalized cash balance plan regulations. This has added leeway to the ways in which asset managers can manage cash balance plans. These new rules include broader options for choosing what is known as the interest crediting rate (ICR) for the plan and also allow the plan sponsor to use different crediting rates for different groups of participants. This way, older employees can use a lower and more conservative investment rate, which allows for a much greater tax-deductible contribution to their plan.
Cash balance plans made up 28 percent of all defined benefit plans in 2015, according to retirement plan consulting firm Kravitz. This is up from just 3 percent in 2001. The number of cash balance plans rose by 22 percent in 2012 alone. This growth is due to many small and midsize companies, especially those that employ high earners, adding cash balance plans to supplement their current 401(k) plans.
Another reason for the explosive growth of cash balance plans is that they provide a great benefit to employees. Employers want to help their most dedicated workers save for retirement, and a cash balance pension plan makes it affordable to do so at higher levels than does a traditional 401(k) plan alone. Because plan owners are required to invest a certain percentage in employees’ retirement accounts, the tax savings are greatly enhanced. This allows the firm to recruit, hire and retain quality employees.
Complexity and Cost
Cash balance plans are more costly to establish than traditional 401(k) plans. Typical cash balance plan setup costs range from $2,000 to $5,000, according to Kravitz, and annual administration fees are approximately the same amount. One of the reasons for this is that there is no one way to define a cash balance plan, and each plan would be unique to each company. That is why it is so important for each firm to work with experts in the fields of tax law, plan design and administration, risk management, and actuary tables.
However, the tax advantages that come with plowing six-figure annual contributions into the cash balance plans outweigh the costs, especially for older business owners.
Bruce certainly feels this way. His goal is to work for another 10 years. If he does so, his actual tax savings will be well over $1 million. When you factor in the growth on that savings as well as the growth of the assets in the tax-deferred cash balance plan, the decision to set up a cash balance plan for his business was one of the best decisions he ever made.
Bill Kanter, J.D., MBA, is an attorney and financial planner in Chicago and the owner of Kanter Wealth Management. Bill may be contacted at email@example.com.