Retirement income planning presents a unique set of complications for small to mid-sized business owners—not only are these clients responsible for their own retirement planning decisions, but they must often make choices that influence retirement savings options for their employees and partners. Further, many of these clients may have been unable to save much during the early years of growing a business, meaning that they need to maximize contributions to tax-preferred accounts later in life.
In these cases, the traditional 401(k) model may simply prove inadequate. Fortunately, a new trend in retirement income planning has emerged—hybrid cash balance plans are rapidly gaining steam as a way to provide business owners with an opportunity to more than quadruple annual retirement savings later in the game.
What Is a Cash Balance Plan?
A cash balance plan is essentially a cross between a traditional defined benefit pension plan and a defined contribution plan (such as a 401(k)). Generally, employers will contribute a set portion of a participant’s salary to the plan each year (a “pay credit”; usually equal to between 5% and 8% annually), and the participant’s account will also be credited with an interest credit each year.
The interest credit may be variable (i.e., it may be tied to a stock index or the 30-year Treasury rate, for example) or fixed. The employer assumes the investment risk associated with this investment credit, so that if the plan provides for a 5% annual investment credit and assets earn only 3% during the year, the employer may be required to contribute more to the plan.
When the participant retires, he or she receives an annuity based upon the amounts that have been credited to his or her account (lump sum options are also permitted). These “accounts,” however, are hypothetical in that the plan assets are not actually segregated into individual accounts, as they are in the case of a 401(k) plan.
Cash balance plans are technically defined benefit plans, so the annual $53,000 total contribution limit (as indexed for inflation) for defined contribution plans does not apply. Instead, the contribution limit for cash balance plans is based on the amount that a participant may receive at retirement (in 2016, a 65-year-old may contribute as much as $245,000 to a cash balance plan, while a 55-year-old may contribute $180,000). An actuary can be used to calculate backward from the benefit amount in order to determine each individual participant’s contribution level.
An employer may offer both a 401(k) plan and a cash balance plan in order to maximize the tax deferral savings available from both types of accounts.
The Ideal Cash Balance Plan Candidate
Cash balance plans may be especially attractive to older professionals or established small business owners who have been unable to accumulate sufficient retirement income savings early in their working years.
For example, the plans have become especially popular with professionals (such as doctors and lawyers) who are often unable to contribute to retirement savings earlier because those funds must be dedicated to paying down student loans. Additionally, small business owners may find that, while establishing a business, the bulk of profits must be funneled back into the business in order to achieve desired growth. These business owners may be especially attracted to the higher contribution limits available with cash balance plans.
Because cash balance plan contributions reduce adjusted gross income, these clients (who often earn higher salaries) can also benefit from reduced tax liability on several fronts through contributing to a cash balance plan. For example, long-term capital gains tax rates and applicability of the new investment income tax are both dependent upon a taxpayer’s income level.