If you already have a 401(k) plan for your business, you’ve seen the benefits it can provide in tax-advantaged saving for retirement, as well as helping to retain staff with a comprehensive benefits package.
But if your business has grown over the years, there’s another plan you should consider adding that will allow highly-compensated partners or employees to contribute significantly to retirement income in a tax-advantageous way, at amounts well above the minimums set for a 401(k) plan.
If you’ve added younger staff along the way, it also has the benefit of incentivizing them, while allowing you to stay within the IRS guidelines. It’s called a Cash Balance Plan (CPB).
What is a Cash Balance Plan (CPB)?
A CPB is a a little different than a traditional pension plan or traditional 401(k) plan. In action, it functions like a combination of the two.
401(k) Plan: The employee contributes up to a set percentage determined by the IRS every year, the employer can match a specific percentage, and the funds are held in an account in the employee’s name and the employee invests them by selecting from a menu of fund options. Investment returns are a big part of the total amount saved for retirement
Pension Plan: The employer promises a specified pension payment on retirement that is predetermined by a formula based on the employee’s earnings history, tenure of service and age. The employee doesn’t have to worry about investing the funds until they receive them upon retirement.
Cash Balance Plan: The employee receives either a lump sum or an annuity on retirement, but it’s held in an individual account structure and is portable if they change jobs. They don’t have responsibility for investing it – the employer sets an annual contribution as a percentage of salary and pays a set interest rate.
Cash Balance Plan Structure
While the participant is an employee, the individual account is hypothetical. It is held on the plan books and credited with annual interest and contributions. In reality, the plan assets can be invested according to an asset allocation the employer determines. On an annual basis, if the underlying investments outperform the annual interest, the surplus accrues to the employer and can be used to reduce future funding contributions. The downside of this is, of course, if the investments underperform the employer must make up the difference.
An Efficient Vehicle for Medical and Legal Professionals
Cash balance plans may be particularly well-suited for medical and legal professionals. They create the opportunity to significantly accelerate retirement savings, in a tax-advantageous way. Since the company will be contributing the cash, your business should consistently produce a high enough level of revenue to cover the contributions.
What is the Tax Impact?
There are advantages to both the practice and the employee. Contributions result in so-called “above-the-line” deductions, which reduce income dollar-for-dollar. For employees, taxes are deferred until retirement, at which point the tax rate may be lower. Let’s look at some numbers.
A 60-year-old doctor wants to retire from her practice in five years. At that age, the upper limit for a CBP contribution is $261,000. Added to the $63,500 401(k) contribution, the annual total retirement contribution is $324,000.1 At a 37% tax rate, that’s a tax saving of $120,065.2 The lifetime limit for these types of plans is currently $2.9 million,23 so whatever point you are at, they may work for you.
Applicable to All Income Levels
CBPs can be structured so benefit levels can be matched to employee needs, as long as annual non-discrimination requirements are met. For example, a flat dollar contribution could be made to owners while other eligible employees receive a percentage of compensation. This is where pairing with a 401 (k) becomes valuable, as it can help to meet the compliance requirements. In addition, because the existing 401(k) plan does not require an interest credit, it can mitigate some of the investment risk of the CBP.
Time for a Consultation?
Even if you have an existing 401(k), adding a Cash Balance Plan can help you create a flexible solution that can provide tax benefits and accelerate retirement savings for owners and partners. There are of course many more administrative and regulatory details that must be thought through, but if you’d like to know more about how a CBP can work for your business, we’re happy to have a conversation.