When people think of retirement planning, they usually think first of a 401(k) plan or a SEP. These plans can be great options, but they have contribution limits that fall far short for many business owners. A defined benefit plan should be considered because they have contribution limits that can often exceed $300,000 annually.
However, before we look at the details of the defined benefit plan, let’s first examine the two main types of retirement structures: cash balance plans and defined contribution plans.
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A defined benefit plan aims to provide eligible employees with a specified benefit at retirement. The benefit amount is contributed solely by the employer. It’s a specific amount that considers participants’ salaries and ages. Upon the normal retirement age of 62, the employee can take the money out of the plan and pay tax at the employee’s ordinary tax rate or roll the funds into an IRA.
In contrast, defined-contribution plans (such as 401(k) plans) specify a maximum contribution that can be made by the employee (as a deferral) and the employer. In a defined contribution plan, the benefit amount at retirement depends on the cumulative plan contributions and interest income, and investment gains or losses.
How do cash balance plans work?
The most common type of defined benefit plan is the cash balance plan. Even though it is a defined benefit plan, employee contribution amounts and the account balance feel like a 401(k) plan. The payout is an account balance compared to a monthly income payment presented in a traditional defined benefit plan. For this reason, cash balance plans are often referred to as “hybrid” plans. Like 401(k) plans, cash balance plan distributions are taxed at the taxpayer’s ordinary tax rate upon distribution.
However, cash balance plans allow the employee to take a lump sum benefit equal to the vested account balance. If a retiree or terminated employee desires, a distribution can generally be rolled over into an IRA or to another qualified plan.
But the surprising part is that these plans work great for small owner-only businesses and employers with less than 20 employees. They are a little more complex to set up and administer. So careful planning is imperative.
Why are cash balance plans such a significant tax and retirement strategy?
They allow the business owner to make substantial tax-deferred retirement contributions. Contribution limits are indexed and adjusted annually based on age. But annual contributions can often exceed $300,000, with $150,000 being the approximate average. This compares very favorably to the yearly limitations of a 401(k) plan.
Let’s take a look at an example. Assume a 56-year-old physician makes $500,000 a year and wants to maximize their retirement contribution. Let’s also assume that the physician has no qualifying full-time employees.
Because of age and earnings, this doctor could contribute up to $230,000 to a defined benefit plan in the first year. The doctor can make additional contributions if the defined benefit plan is combined with a solo 401(k). Not such a bad deal.
These contributions are fully tax-deductible and can be made up to the date the tax return is filed (including tax extensions). The contributions will grow tax-deferred but will be subject to tax at the presumably lower tax rate in retirement.
Cash balance plan for small business
Let’s look at a few strategies that can be used.
- Only Include 40% of the Employees. You should be aware that the cash balance plan is not entirely required to cover all employees; in fact, IRS only requires 40% of employees to be covered. Section 401 (a) (26) requires that 50 employees or 40% of them, whichever is lesser, receive benefits under the plan and that the contributions should be meaningful. A business owner could consider the age-weighted capacity of the cash balance plan and eliminate some older employees allowing for an overall lower employee contribution while providing significant benefit.
- Combine Cash Balance Plan with 401 (k) and Profit-sharing Plans.
Cash balance plans are not always the ultimate security after retirement; you will need additional income from profit-sharing or 401(k) plans. A good plan combines profit-sharing and 401(k) alongside a cash balance plan.
- Include your Spouse in the plan. If your spouse is employed and included in the business payroll, it is best to have them in the cash balance plan. A spouse on payroll can receive benefits; they can contribute to the available cash balance plan, profit-sharing, or 401 (k) plans.
- Set Higher Wages for Yourself. Contributions to a cash balance plan consider the level of compensation one has. The owner can increase their W-2 wage to increase their contribution to the cash balance plan. This could also be applied to the owner’s spouse. Even though this will lead to higher income taxation, the company will get a higher deduction, and the owner will get a more considerable contribution towards social security.
- Consider Overfunding. You may be able to overfund the plan a bit. This is usually the case in the early years of plan set up.
Take a close look at the example above. As you will notice, not many retirement structures allow such significant contributions. A 401(k) plan does not even come close.
Cash balance plans are great options for:
- Business owners who have consistently high profits.
- Professional service companies (physicians, attorneys, consultants, etc.).
- Owners who have fallen behind on retirement and are looking to “catch up.”
- Owners in high tax brackets looking for tax deferrals.
If you think a defined benefit plan is right for you, make sure that you review your situation with your financial advisor and CPA. Hopefully, a defined benefit plan will become a beautiful tool in your retirement arsenal.