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Cash Balance Retirement Plan: The Solution to Accelerate Savings, Reduce Taxes and More

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Although April 15th was weeks ago, the impact of paying income taxes may still have a lingering affect for many people.

Many of these people are business owners or high income professionals who find themselves with a retirement plan dilemma. They have high earnings but inadequate retirement savings, due to limits on 401(k) tax-deferred savings and also because they have invested heavily in building their business or professional service practice. 

If you happen to find yourself in this situation, and would also like a significant tax deduction, adding a Cash Balance Plan may be the perfect solution. Cash Balance Plans provide participants with an annual pre-tax contribution limit of up to $275,000, typically double or even triple what is allowed in a 401(k) profit sharing plan ($59,000 if age 50 or older).

Tax-qualified retirement plans are broadly divided into two categories:

  1. defined contribution plans, like a 401(k) plan
  2. defined benefit plans, like a traditional pension plan

If you have a 401(k) plan you can contribute up to $24,000 if 50 years or older and $18,000 if less than age 50. When a profit sharing plan is added another $35,000 can be contributed. Once you have reached the combined annual maximum contribution of $59,000 then no further contributions are permitted, which simply may not be enough to fund a retirement these days.

Since these contributions are tax deductible, it may be possible to accumulate a retirement benefit of more than $2.6 million over 10 years. If income tax rates rise in the future, this tax deferral feature becomes more attractive.

In addition, if someone who is 50 years of age today and participates in all three retirement plans may be able to defer in excess of $3.5 million without consideration of investment growth potential.

The Cash Balance Plan is deemed as a hybrid retirement plan since it takes on characteristics from both the defined contribution and defined benefit plans. Each participant has an individual or hypothetical account similar to a 401(k) plan. Employers make contributions to each participant’s account with annual pay credits (contribution) and interest credits (typically around 5%).

Furthermore, unlike a 401(k) plan, the participant does not have any investment risk.

The nature of Cash Balance plans and the investment structure typically insulates them from market volatility. The investment goal for a Cash Balance Plan is to protect the tax deduction rather than maximize investment returns. The investment goal for the investment manager is to optimize the returns by meeting the interest credit rate each year.

When paired with a 401(k)/profit sharing plan, the two plans are combined for nondiscrimination testing. The Cash Balance Plan combination arrangement allows maximization of benefits to owners and other “key” participants while keeping employee contribution costs relatively low. Contributions can be a percentage of salary or a flat dollar amount and are stated in the plan document.

Cash Balance Plans are “defined benefit” plans. Therefore, the contributions and interest credits are NOT discretionary and an actuary provides the funding requirement to the plan sponsor. Employers can designate different contribution amounts for various participants which allows for greater flexibility. Once participants retire or terminate employment, they are eligible to receive the vested portion of their account balance. In addition, Cash Balance Plan accounts are portable and can be rolled over to an IRA.

Cash Balance Plans For Business Owners

Generally, Cash Balance Plans are an ideal retirement plan for business owners and professional service practices where the following exist:

  • Partners and/or owners with annual income exceeding $250,000,
  • Partners and/or owners who want to contribute $50,000 or more above and beyond their 401(k) plan contribution,
  • Achieve a relatively steady cash flow, and;
  • A willingness to contribute up to or greater than 5% of pay to employee retirement plans.

Cash Balance Plans are relatively easy to create and manage. Professional service practices (fields of accounting, law, medicine or dentistry) that are profitable and are seeking tax deductions will find the Cash Balance Plan an extremely attractive retirement plan vehicle. Another attraction is the defined benefit plan is protected from their creditors. In today’s litigious society, a Cash Balance plan can be used to protect doctor’s assets.

Another attraction is that the business’s defined benefit plan is protected from their creditors. In today’s litigious society a Cash Balance Plan can be used to protect owners and partners’ assets. Keep in mind that a Cash Balance Plan must be established by December 31st to take advantage of tax deduction in 2015, although the plan does not need to be funded until the firm’s tax return is due.

Finally, if concerns exist about the amount of taxes you’ll have to pay or the volatility of your retirement plan portfolio or maybe that you are late to the game in saving for retirement, consider the addition of a Cash Balance Plan for your professional practice.

The combination of an existing or start-up 401(k) and profit sharing plan with a Cash Balance Plan can provide significant opportunity to reduce taxable income, be a great wealth accumulation vehicle and be a more powerful means for securing the retirement of professionals and business owners alike.

This is a guest contribution James J. Di Gesu, CPA, PFS, MBA. James is the Sr. Vice President of Wealth Health LLC.

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