After spending years funneling all extra cash into the growth of a business, many small business owners find themselves in the same boat: a very high tax burden with an inadequate nest egg for retirement as they approach their 50's and 60's. While defined contribution plans such as 401(k)'s or profit sharing plans allow for $54,000 contributions ($60,000 if over the age of 50), some are still looking for ways to turbocharge their retirement savings.
In the 1980's and 1990's, defined benefit plans that would allow for a flat dollar amount benefit or a percentage of final salary were a common way to tackle this problem. However, due to the cost and complexity of offering these plans, their use has fallen dramatically. In 1986 there were 173,000 private defined benefit plans in place. According to the Department of Labor, that number had fallen to just 44,000 in 2012.
However, one area that has seen a surge of interest is the cash balance pension plan. In 2013, there were over 11,000 active cash balance plans as compared to just 1,300 in 2001. One of the reasons for the rise of the cash balance plan came from the Pension Protection Act of 2006 (PPA) which enacted laws that recognize the legality of cash balance plans that meet specific requirements set forth in that legislation. Further clarifications in 2010 and 2014 have made these plans more flexible and easier to administer, making them increasingly popular among small business owners. Almost 50% of today's plans are in businesses with fewer than 10 employees.
How Do Cash Balance Plans Work?
Cash balance plans are similar to traditional defined benefit pensions with a 401(k) twist. When designing the plan, you will select the amount you wish to contribute to your employees and the guaranteed interest rate that the funds will appreciate at. For example, you might offer to contribute 6% of your employees' salary each year with a guaranteed growth rate of 5%.
An investment account will be created for all of the cash balance plan's assets to be managed toward that 5% interest rate. An actuary will then calculate the estimated amount you will need to contribute to the account to meet those promises- let's call this $100,000 per year. In years that the account earns greater than 5%, you will be able to contribute less than $100,000. In years that the account performs poorly, you will need to contribute more than $100,000.
Each participant will receive a "hypothetical" statement that shows what their benefit would be at retirement. If they leave prior to having 3 years in the plan, they will forfeit their balance and it will be used to decrease future contributions. If they leave after 3 years, they would have the option to take their portion with them to an IRA or new employer.
The real kicker here is just how much owners can defer for themselves into the plan. Click here for a chart that gives you a great idea, based on your age, of what those scenarios look like. Here are a few examples:
As you will see, if a 50 year old just had the 401(k) and profit sharing plan, they would defer $60,000 away for themselves. However, when adding the cash balance plan, they can defer another $141,000, for a total of $201,000! These amounts escalate with age but do limit you to 100% of your income, a total balance of $2.7 million, or an annual benefit of $215,000.
How Do The Tax Savings Compare To The Costs?
Profitable business owners know that tax deductions are important to retaining profits but are hard to find. This is why your 401(k) contributions have been so important thus far. You are likely paying a combined 45% in federal and state income taxes, while your investments get taxed at a 23.8% capital gains rate. However, contributions to your 401(k) grow tax deferred- you avoid the capital gains tax and defer the income tax until you take the money out in retirement. During that period of time, you will be in a much lower tax bracket and will work with your financial advisor to withdraw the funds in a tax efficient manner.
Cash balance plan contributions work exactly the same way on a much larger scale. Most owners will see immediate tax savings. The 50 year old mentioned above would save $63,000 in taxes on his $141,000 contribution assuming a 45% combined federal and state income tax rate. While in retirement, you will either withdraw the funds at a lower income tax rate, donate the funds to charity to receive a tax deduction, or leave them to your heirs who may be in a lower income tax bracket than you were at the time of your contribution.
Of course, there will be costs to installing the plan:
-You will be required to make contributions to your employees. However, contributions made to a 401(k) on their behalf count toward this requirement.
-A setup fee could range between $2,000 and $5,000
-Annual administration costs will range between $2,000 and $10,000
Before installing the plan, a third party administrator will run an analysis based on your income and the demographics of your employees. Here, you will be able to clearly see whether these costs outweigh the benefits described above. However, if you fit any of the categories below, it is likely that you will consider the cash balance plan a no-brainer for your business.
Who Should Consider A Cash Balance Plan?
First and foremost, cash balance plans should only be considered by businesses with consistent profit patterns. Keep in mind, the plan requires contributions during both economic expansions and recessions. Assuming your business has had stable profits, we have found that the following are good candidates:
-Partners or owners who wish to contribute more than $50,000 a year to their retirement accounts.
-Companies already contributing 3-4% to employees, or are at least willing to do so.
-Partners or owners over 40 years of age who wish to "catch up" or accelerate their retirement savings.
-Sole proprietors or family businesses with significant cash flow.
-Law firms, medical practices, accounting firms, engineers, architects, financial services, management consultants and many others with a high percentage of highly compensated employees.
-Those who wish to enhance the benefits of select executives or who are looking to attract high caliber employees.
How Do I Learn More?
First National Corporation serves as the investment advisor for several cash balance plans, including our own. We will work with you and a third party administrator (TPA) to provide an analysis on your business and see if your demographics make sense for the plan. This quote is provided free of charge. If you chose to move forward, we would select the appropriate investments to reach your desired investment return while working with the TPA to keep your plan compliant.
For an initial consultation, please contact us using the linked form and briefly describe your situation. We look forward to speaking with you and learning how we can help you and your business.