Entrepreneurs are a unique breed. Their willingness to take large risks early in their careers creates opportunities to make large amounts of money later on. In the process of building their business from the ground up, however, most entrepreneurs pump every dollar they have into making the business profitable. Reinvesting the profits back into the business may help it expand, but this often leads to entrepreneurs forgoing contributions to traditional retirement vehicles such as 401ks. Therefore, while they have a large asset on their balance sheet from the business, their wealth is very concentrated in an illiquid asset. And while they may make large amounts of money later in their careers, later contributions to a 401k won’t be enough to make up for all the missed years of retirement savings.
Thankfully, there’s a retirement vehicle for this exact problem. Cash balance plans let business owners save well above the normal limits of a 401k plan, potentially contributing hundreds of thousands of pre-tax dollars. Cash balance plans can help business owners close the gap on their retirement savings while providing considerable tax deferral benefits.
Closely held businesses and high earning sole proprietors have one of the biggest tax planning opportunities in the IRS tax code at their advantage. In previous articles, Denver PWM has explained some of the advantages of 401k plans that have profit share components. But for a select few kinds of companies such as…
- Real estate development firms
- Doctor’s offices
- Law firms
- Consulting groups
- Closely held business with a few high earning individuals and support staff
…not only do cash balance plans let you potentially contribute six-figure sums on an annual basis to pre-tax retirement accounts, but they’re also protected from creditors should you ever be sued or go bankrupt. This little-known planning technique is called a defined benefit plan. Cash balance plans are a subset of these defined benefit plans.
Who cash balance plans are perfect for
- The fewer employees you have, the better.
- This planning technique works best when there are a few high earning individuals all looking to shelter large amounts of income and a couple lower earning support staff who are far younger than the high earners of the firm.
- Because the benefit is calculated on the basis of income amount and age, having younger support staff will let you shift more of the benefit into the owners’ pockets without making it too expensive.
How cash balance plans work
Most companies implement 401k plans because they are a “defined contribution” plan where the burden of saving is on the employee and not the company. By contrast, pensions put the burden of funding retirement on the company for the benefit of the employee. Cash balance plans are a form of pension, and while not as common it lets you give an additional benefit completely separate from the company’s 401k plan. Because business owners own the business but also get paid a salary as an employee of the business, it creates an opportunity to use the profits to fund yourself as an employee of the company. As an additional benefit, Cash Balance plans sit on top of 401ks so you don’t have to sacrifice maximizing your 401k, and can still save up to an additional $200,000+ in the cash balance plan. As a refresher, please read up on how 401ks work in our previous article. The downside to these pension plans is they can be inflexible in their funding requirements and require a team of smart people working to keep you in compliance.
But there’s always a catch
The IRS isn’t going to let you shelter hundreds of thousands of dollars in income without meeting certain stipulations. First, cash balance plans must have a consistent funding level put in place for a minimum of 5 years. While 401ks allow you to vary the amount you file away depending on cash flow, cash balance plans are different. Basically, the government wants to ensure this huge tax deduction is being used for the actual purpose of the pension plan- the business putting away money for its employees’ retirement!
There are some other factors you’ll want to consider before setting up a Cash Balance plan. For one, the level of benefit you’re allowed to access is based primarily on your age. The older you are, the more you can save in the plan for yourself every year above and beyond your 401k. The calculation for this is extremely complex, and we strongly suggest checking with an actuary for precise information. Broadly, however, the calculations look something like this:
As you can see, the benefit from a tax perspective can be enormous for someone that is in the highest federal tax bracket. While cash balance plans help you save on federal and state income tax, it’s worth noting these savings also avoid payroll taxes, which can be another 15.3% in savings for owners as they get the deduction of 7.65% as the employee and another 7.65% as the employer!
Cash balance plans are the Ferraris of planning techniques. They are incredibly sophisticated and can be very expensive from a funding and fee cost. However, for the right situation they can help you save hundreds of thousands of dollars in taxes annually and can be a slam dunk for business owners. It’s worth noting the complexity involved with these plans. Make sure you are working with a financial advisor who is experienced in dealing with these types of planning techniques and can help assist you through the implementation of a cash balance plan for you and your business.
Denver Private Wealth Management is an independent fee-based financial planning practice with 80+ years of experience in the financial industry. DPWM customizes portfolios based on your financial goals and works closely with you, your tax advisors and estate attorneys to form a comprehensive view of your financial situation. For more information or to set up a free consultation, contact us at firstname.lastname@example.org.
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