Business owners are generally great at running their business. However, they are so laser-focused on running the business that the “unimportant” things, such as saving for retirement, are sometimes pushed to the side or are forgotten altogether.
Because of this unfortunate trend, business owners often find themselves needing to “catch up” as their retirement date approaches. The impetus to act is generally triggered by one question – How can I stop paying so much in taxes?
Fortunately, there is some good news. There is a way to kill two birds with one stone – saving for retirement and saving on paying taxes. This good news comes in the form of a cash balance plan.
A cash balance plan is a strategy that business owners can implement to supercharge their retirement savings and defer taxes.
What is a Cash Balance Plan?
As a business owner, you have many resources available to help you save for retirement, most commonly a 401(k) or a profit sharing plan. While these are great solutions that meet many business owners’ goals and objectives, for some the maximum annual contribution of $52,000 may not be enough.
A cash balance plan allows you to save more – potentially a lot more. A cash balance retirement plan allows for annual contributions of up to $250,000 per year, pre-tax, into a retirement plan. That’s $250,000 that won’t be going on your tax return, which means saving upwards of $100,000 or more in tax.
Who Does a Cash Balance Plan Work For?
Cash balance plans work great for privately held and family businesses. They are also ideal for professional organizations, such as doctor’s offices, accounting firms, and engineering companies maxing out their 401(k) and profit sharing plans and are now seeking additional methods for deferring taxes. These plans can also work for solo consultants bringing in high revenue.
Generally, the older you are, the more you make, and the younger your staff, the greater the advantages of this type of retirement plan.
How does it work?
401(k) and profit sharing plans are known as defined contribution plans. This means that the employee makes a required contribution each year. After making the contribution, the employer is off the hook, no longer responsible for whether the account goes up or down in value. They have met their responsibility.
A cash balance plan is a defined benefit plan. The business is making a commitment to pay a future financial benefit to themselves and their employees.
The amount of the future commitment is actuarially calculated annually based on income, years of employment, and age (in other words, really smart people do awesome calculations to tell us what is owed, but this may increase overall expenses compared to a 401(k) plan).
What are some of the advantages of a cash balance plan?
Cash balance plans offer benefits for both business owners and employees. Business owners are allowed to defer larger amounts into a retirement plan, thereby saving on current taxes and significantly increasing their retirement savings. Employees benefit from the contributions that employers are required to make on their behalf.
As a business owner, it is possible to defer $250,000 or more per year into a pre-tax retirement plan. For illustrative purposes, let’s assume a hypothetical contribution of $275,000 and a 40% tax bracket; this means a potential tax savings of $100,000.
For business owners looking to accelerate their retirement savings, a cash balance plan is a great option.
What are some of the disadvantages?
The first disadvantage of a cash balance plan is cash flow. The business owner is required to make annual contributions to the plan. The financial commitment, depending on any number of factors, may be large. To compensate for this risk, the business owner should be confident that the cash flow of the business is sufficient to consistently contribute (it’s worth nothing if it is designed correctly; the largest portion of the financial commitment will be going to the business owner’s account).
A second disadvantage is the liability. As the business owner establishing the cash balance plan, you are guaranteeing future payment to yourself and your employees. If the investments in the account do not perform as anticipated, then the business will be “on the hook” for making up that shortfall.
So what now?
If you are a business owner who is
- Maxing out your retirement plan,
- Looking to increase retirement savings,
- Seeking to defer taxes,
- And/or searching to add more benefits for your employees,
then a cash balance plan should be something to consider.
An experienced advisor, accountant, or third-party administrator is a good place to start. They should be able to determine whether a cash balance plan is a good fit for your business.
None of the information in this document should be considered as tax advice. You should consult your tax advisor for information concerning your individual situation.