Tax-Deferred Savings of $200K to $500K Annually for Business Owners, with Minimal Employee Costs

Using a defined-benefit cash balance plan, solo and small business owners, professionals and profitable entrepreneurs can readily save three to ten times more than in traditional tax-deferred retirement savings plans, while minimizing the portion of total plan costs allocated to employees. As a result, 90% or more of total plan contributions are allocated to selected participants, in full compliance with IRS non-discrimination and participation rules.

What is a Cash Balance Plus Plan?

A cash balance plan is a defined benefit plan with some of the characteristics of a 401(k) plan. The Pension Protection Act of 2006 (the "PPA") enabled the combination of a defined benefit plan with traditional 401(k) and profit-sharing plans. The PPA expanded tax-deferred retirement planning beyond the limits of traditional IRA, 401(k), and other qualified accounts. The PPA offers flexibility for designing a specific, customized retirement plan that raises limits on tax-deferred saving and ultimately provides each covered individual a funded pension. PPA plans fall under ERISA (Employee Retirement Income Security Act of 1974) rules and thus are fully asset-protected.

With traditional pre-PPA qualified retirement plans, an owner must make significant contributions to employees. Using PPA rules, however, the business owner significantly lowers the costs allocated to employees who are not owners. The percentage of the total plan contribution for owner(s) with employees can exceed 95%+ of the total.

Further, instead of maximum annual tax-deductible contribution limits of $61,000 ($67,500 at age 50+) in 401(k) profit-sharing plans, a business owner using a Cash Balance Plus plan can typically deduct from $200K to $500K, even up to $1 million, annually.

Supercharged Retirement Saving

Cash balance plans offer owner-employees a vehicle to defer tax on income well in excess of the annual contribution limits of traditional 401(k) and profit-sharing plans. At retirement, participants can take an annuity based on their account balance. Some plans also offer a lump sum, which can be rolled into an IRA or another employer's plan.

Many older business owners are turning to these plans to supercharge their retirement savings. Cash-balance plans have generous contribution limits that increase with age. People 60 and older can readily save over $300,000 annually in tax-deductible contributions.

Tax-Deferred Retirement Saving

Traditional defined-contribution retirement plans are valuable and well-known methods of tax deferral, but federal limits on contributions to Sec. 401(k) and profit-sharing plans cap this tax-planning strategy at relatively low levels. The maximum contribution into defined contribution plans is $61,000 in 2020 (up to $67,500 for persons age 50+.)

Since cash balance plans are defined benefit plans, contributions are not subject to this cap. Instead, the limitation is on the annual payout the plan participant may receive at retirement ($245,000 as of 2022). To optimize tax deferral and retirement savings, a cash balance plan can be used in conjunction with one or more of a § 401(k) plan, a profit-sharing plan, and a § 401(h) medical expense account; hence, "Cash Balance Plus". This paper focuses on cash balance plans because a cash balance pension plan under PPA rules is at the core of any Cash Balance Plus design.

The annual tax-deferred contribution limit of an individual in a cash balance plan depends on age and salary, and the amount is calculated by an actuary each year. An exemplary contribution limit for a person aged 45-49 might be $170K, while the limit for a person aged 60-62 could be $320K. These limits can be increased in a Cash Balance Plus design, however, through the combination of 401(k) accounts, profit sharing, 401(h) accounts, spousal participation and several other techniques.

An advantage of PPA pension plans is the flexibility to contribute large amounts for older owners and to minimize contributions for non-owner employees. This can be achieved in full compliance with nondiscrimination and minimum participation rules of Internal Revenue Code (IRC) §§ 401(a)(4) and 401(a)(26).

The Pension Benefit Guaranty Corporation (PBGC) is a federally chartered corporation established under ERISA in 1974. The PBGC guarantees voluntary private defined benefit plans. Professional service companies having fewer than 25 employees are non-PBGC, which status limits profit sharing to 6% of compensation (instead of 25% for PBGC businesses). A Post-Retirement Individual Medical Expense (PRIME) account under IRC § 401(h) can be used to increase tax-deferred saving for owners and key employees in non-PBGC companies. The PPA governs 401(h) plans, which are a type of pension plan.

Cash Balance Plans Protected against Creditors

Cash balance plans are protected against an individual's (and a business's) creditors by ERISA and the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005, as affirmed by the U.S. Supreme Court.

Valuable Features of a Cash Balance Plus Design

Cost. Cash balance plans can reduce overall retirement plan costs since benefit targets are based on current salary.

Flexibility. Plans provide maximum flexibility to reach cost and benefit goals. Particularly, plans can be designed to provide greater allocations to older and/or key employees and still satisfy non-discrimination rules. Plan benefits can be distributed as an annuity or in a lump sum.

Simplicity. Plan designs and benefits can be easily explained to employees, who can readily grasp the value and mechanics of the plan.

Portability. Plan values can be ported to other accounts upon retirement, termination of the plan, or end of employment.

Security. Plans are protected against creditors. For companies with more than 25 employees, plans are guaranteed by the PBGC.

Tax Deferral. Similar to other qualified pension plans, contributions are fully tax-deductible to the business and benefits grow tax deferred.

Qualified Business Income Deduction. The new tax laws effective 2018 provided a 20% income tax deduction on qualified business income (the "QBID"), but service businesses did not get an unlimited deduction. For professional service businesses, the QBID is gradually phased out when taxable income reaches about $170 ($340K for couples). Tax deductions from a qualified retirement plan, however, can help reduce taxable income and thereby save the 20% QBID benefit or at least part of it.

How a Defined Benefit Cash Balance Plan Works

The account balance (the plan benefit) grows in two ways: a contribution credit and an annual interest credit. Both the contribution and the interest credits are "defined’ (i.e., specified) in the plan documents and are subject to IRS rules.

At the end of every year, the plan’s actuary calculates the contribution credit (amount) for each participant based on plan design, actuarial assumptions, and IRS regulations. The annual interest credit is guaranteed and independent of the plan’s investment performance. The annual interest credit rate may be tied to an outside index, such as the one-year U.S. Treasury Bill rate. Often the annual interest credit rate is a fixed guaranteed return that all participants receive; for example, between 3% and 5%, and fixed for the duration of the plan.

This does not mean that the plan investment portfolio must have a return equal to the crediting rate. It often does not. When the portfolio return is below the annual interest credit rate very long, the plan becomes underfunded. Consistent portfolio returns above the credit rate result in an overfunded plan. At plan termination, the plan sponsor is liable for a shortfall in an underfunded plan. On the other hand, the excess amount in an overfunded plan could be subject to as much as 100% excise tax. So, it is advisable to manage the plan portfolio in a manner to avoid under- and overfunding. When a plan is underfunded, annual contributions can increase, while an overfunded plan lowers annual contribution limits.

A cash balance plan portfolio is usually conservative. Since the defined annual credit rate is usually 3 – 5%, high-risk investments to achieve high returns are unnecessary. Inversely, since the plan sponsor is liable for underfunded accounts, risky exposure to market downturns should be avoided. A conservative annual interest credit rate, however, should not be a deterrent to starting a Cash Balance Plus plan. Compared with after-tax investing, a cash balance plan is still a better choice for nearly everyone in higher tax brackets. Also, since a Cash Balance Plus design typically also includes a 401(k) component, an individual participant may maximize the 401(k) plan allocations (up to a limit) and invest 401(k) assets aggressively. Thus, the cash balance allocation could be viewed as the fixed-income bucket of an overall diversified, managed-risk retirement portfolio.

Assets in a cash balance plan are generally managed with the help of an investment adviser. On an annual basis, participants receive a statement illustrating their account balance, which equals the lump sum value of their benefits under the plan. In this sense, a cash balance plan is similar to a 401(k) plan, in which a participant can track his personal account balance. Statements include a beginning-of-year account balance, credited interest for the year, the employer provided contribution and an end-of-year balance.

When an individual's account terminates for one reason or another, the account balance may be ported to another tax-advantaged account until distributions are needed.

As noted above, contribution limits of a cash balance plan differ from traditional qualified retirement saving plans and defined benefit plans. Contribution limits of a cash balance plan are age dependent, and they vary with each individual and set of circumstances. All other things being equal, a contribution limit is more for an older person than a younger one. This is because an older person has less time to reach the maximum pension benefit limit (discussed below). The age-based limits enable business owners and employees to “catch up” on retirement saving.

Company Demographics Make a Difference

A cash balance plan under PPA rules allows greater contributions for older individuals because they have less time to save. As a result, a dominant portion of a business's total plan costs can be allocated to older participants and still satisfy non-discrimination and minimum participation rules. So, for example, if an objective of a plan is to allocate an overwhelming portion of total contributions to older owners and older key employees, then demographics matter. All other factors being equal, the greater the age differential between older owners and younger employees, the higher the proportion of total plan costs go to the older owners; for example, up to 95% or greater. For large businesses, the demographics are less important than in small businesses.

Solo Business Owner

A Cash Balance Plus Plan can also be designed for solo business owners with or without employees, depending on circumstances. As with plan designs generally, if the business includes employees, the greater the age differential between older owners and younger staff members, the more favorable are the allocations to owners. A Cash Balance Plus Plan makes sense for an owner who can afford to save at least $150K annually. A solo cash balance plan just for an owner who has no employees is less complicated, more flexible, and easier to administer.

Withdrawals Before Retirement Age (age 59½+)

If an individual leaves employment, a cash balance plan can be rolled over into an IRA or to another company's retirement plan. Similarly, when a business terminates a plan, an individual's account balance is rolled over into an IRA. An employer can "lock up" a plan to prevent withdrawals other than rollovers to other plans. Any early withdrawals from a company plan or from a solo plan face a 10% penalty charge in addition to regular income taxation.

The Maximum Amount That Can Be Saved

The lifetime maximum, indexed to inflation, is currently about $3.1M for an individual age 62+. For younger participants, maximums are considerably less (e.g., about $1.4M at age 40). The lifetime maximum is based on a "maximum annual benefit" based on an individual's compensation. In 2022, the maximum annual pension benefit of a cash balance plan may not exceed $245K.

Plan Duration

For solo firms, plans typically exist for a short period of time (e.g., 10 years or less). At maximum contribution, a plan would be ‘maxed out’ after 10 years. An owner/partner can no longer make contributions into a cash balance plan after reaching the lifetime maximum amount. For plans with multiple participants, termination of one account from the plan does not substantially impact the plan. Contributions on behalf of other participants can continue and the plan can be adjusted indefinitely as new participants join the plan and older ones retire.

Good Candidates for a Cash Balance Plan

A good candidate for a cash balance plan is any business in which the owner(s) and/or key employees want to save $150,000 or more annually in a tax-deferred manner. A cash balance plan is particularly useful for older individuals who need to catch up on retirement saving and wish to minimize plan costs of employees. Professionals (e.g., CPAs, attorneys, health service providers) and other small business owners often get a late start saving for retirement. A Cash Balance Plus plan gives them the opportunity to condense decades of saving into a few years.

Administration, Set-Up Costs & Annual Management Costs of a Cash Balance Plus Plan

The cost of setting up and managing a Cash Balance Plus plan is comparable with the cost of a 401(k) plan when all necessary service providers are considered. Formally, the plan sponsor (business) is the plan trustee and has fiduciary duties to plan beneficiaries. Generally, the plan sponsor uses service providers to set up and administer a plan and to manage plan assets.

Setting up a plan requires an actuarial analysis of each plan participant and drafting of plan documents. The actuary calculates contribution limits for each participant and how contributions are allocated. Each year the actuarial analysis is updated and required documents are prepared and submitted. Usually, plan assets are held in a custodian's account. Additionally, an investment adviser selected by the plan sponsor manages the plan's investments.

There is no template for a Cash Balance Plus plan. Each plan is customized for each business and its plan participants. This author's recommended plan designer includes Enrolled Pension Actuaries and is a third-party administrator (TPA). It provides initial actuarial analysis and set-up documents, and annually thereafter the required actuarial services and regulatory documents.

For example, a set-up fee could be about $6K, and initial and annual administration fees could be in a range of $6-10K, depending on business size.

Larger businesses with more than 25 plan participants must also pay insurance premiums to the PBGC.

Contact Thomas Swenson for additional information about Cash Balance Plus plans or to learn more about other products and services that reduce risk while building financial security and peace of mind.

Copyright © 2022 by Thomas Swenson

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