By Vanessa McElwrath, CFP®,CPA, ML&R Wealth Management
A retirement plan should make the absolute most of your earnings during your working years but not all of them work the same. If you are a high-earning small business owner or self-employed individual, a 401(k) or traditional profit-sharing plan alone might not be the best for your money.
That’s because there is an often-overlooked type of retirement plan that can offer some significant advantages: a cash balance plan.
Technically, a cash balance plan is an employer-sponsored defined benefit plan, but it’s often referred to as a “hybrid plan” because there are elements of it that are similar to both a defined benefit plan – one that provides a specific benefit at retirement for each eligible employee, and a defined contribution plan – one that specifies the amount of contributions to be made.
A cash balance plan is a defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance.
The hybrid format of a cash balance plan allows for larger tax deductions and accelerated retirement savings of a defined benefit plan, while maintaining some of the flexibility and portability of a defined contribution plan. The benefits of this hybrid model boil down to a few key areas.
Pre-tax savings – Because these plans qualify for ERISA (The Employee Retirement Income Security Act of 1974), taxes on contributions are deferred until the account is drawn. Contributions to the plan also reduce your taxable income dollar-for-dollar.
Investment stability – Cash balance plans grow in two ways, through contributions and interest credits. Employers bear the risk of the investment, and the interest credit is locked in place, usually based on the 30-year Treasury Securities Interest Rate of 5%.
Flexibility – Cash balance plans are designed to be implemented in conjunction with a 401(k) and profit-sharing plan. This means it’s not an either/or decision, but lets you stack the benefits of a cash balance plan onto your existing plan.
How much can you contribute?
One of the main advantages of a cash balance plan is that they are not subject to the same limits on pay-ins as other plans. Contribution limits are set on a sliding scale according to age. Older individuals may be able to defer more than 4 times the amount of traditional plans, over $200,000 in some cases, but each partner/owner can choose his or her own level of contribution.
There are many things to like about the cash balance plan system, but it only works for certain retirement savings situations. You should investigate it further if you or your business partners fall under the following descriptions:
For example, let’s say you spent your early career pouring your own money into your company, and are now looking for ways to accelerate your savings before retirement. You would be a great candidate for this type of plan. It’s a good match for self-employed individuals like real estate agents, or small businesses like doctors’ offices and legal firms.
If these descriptions fit your situation, a cash balance plan could be just what you’re looking for, but there are a few other things to consider.
First, bear in mind that these plans work best in businesses that yield steady excess cash flows. It would not be advisable to go through the process and expense of setting one up if you are not confident your business will be able to continue its current level.
Next, you should consider the costs-to-benefit ratios for creating and administering a plan. Requirements like drafting plan documents, retaining the services of an actuary, and filing an annual Form 5500 must be weighed against the value added by the extra savings.
There is not an exact dollar income amount at which you can say with certainty that a cash balance plan becomes advantageous, but as a rule of thumb, if you and your business partners have personal annual income that exceeds $270,000, and are seeking an annual tax deduction of $61,000 or more, a cash balance plan makes sense.
Employee demographics are also important. This type of plan offers the greatest benefits to income earners who are close to retirement, especially those with few or no employees. 15 employees per owner is a good rule of thumb, and because contribution limits increase by age, it usually makes the most sense if you and your business partners are older than your employees.
Remember, these plans must be offered company-wide, so consider your company’s ability to extend these benefits to all your employees against your personal capacity to save more. If you are considering this plan, you likely already fund, or are considering funding, an employer contribution of 5% or more of employee compensation in a safe harbor 401(k) or profit-sharing plan.
If you want to learn more, the experienced plan advisors at ML&R Wealth Management will be glad to walk you through cash balance plans or other retirement plans for high-income earners. Contact us today for a consultation.