By Matt Gallagher
Your Finances
Matt Gallagher
Small business owners, and in particular professional practices such as attorneys or physicians, are always looking for ways to reduce their tax burden and defer more of their income. While traditional 401(k) and profit-sharing plans are useful, other vehicles such as a cash balance plan allow for much higher contribution levels.
A cash balance plan is technically classified as a defined benefit plan, which means it is subject to minimum funding requirements. Likewise, the investment of cash balance plan assets is managed by the employer or an investment manager appointed by the employer. Since cash balance plans are a “benefit,” increases and decreases in the value of the actual plan’s investments do not directly affect the amount promised to employees.
For example, if Jane is promised through a cash balance plan a $10,000 account value, then she is entitled to a $10,000 payment, whereas the actual value of Jane’s account could be $8,000. The employer is responsible for making Jane’s account whole. On the other hand, her account could be worth $12,000, yet she is only eligible to claim the $10,000 promised her.
Typically, an employee benefit is expressed as a hypothetical account balance, giving it a defined contribution “feel.” A participant’s account is credited each year with a “pay credit,” usually a percentage of pay, and also with an “interest credit,” either a fixed or variable rate that is tied to an index. When a participant is eligible to receive benefits under a cash balance plan, the plan is treated as if it were a defined contribution plan with distributions available at termination of employment in the form of an annuity or a lump sum that can be rolled over into an IRA.
Cash balance plans are especially suited for self-employed or small business owners with high incomes, since these plans allow high-earning business owners to save more than the $56,000 currently allowed for profit sharing and 401(k) plans. Cash balance plans have generous contribution limits – upwards of $200,000 in annual wage deferral.
These plans allow for large annual tax deductions because the limitation is on the annual distribution that the plan participant may receive at retirement ($225,000 for 2019), not on the annual contribution to the plan. Employer contributions to a cash balance plan could potentially be three to four times their profit sharing/401(k) contributions and will vary depending on age, income, employee payroll and how much is currently invested in the plan.
Most cash balance plans are designed for the primary benefit of owners or executives of a company. Some candidates include professional practices (doctors, lawyers, accountants, architects, agencies, family-owned businesses) who would like to minimize taxes by putting away their hard-earned dollars into tax-deferred accounts. Additionally, cash balance plans can be appropriate when the owner or executive-level employees are several years older than most of the non-highly compensated employees.
For more specifics, it’s best to speak with a retirement plan advisor and third-party administrator for a sample plan design proposal.
This sounds too good to be true, so what’s the catch? Downsides to sponsoring a cash balance plan include the need to commit to annual minimum funding levels, annual administration fees, investment management fees and actuarial fees associated with the annual certification requirement showing that the plan is properly funded. The tax savings usually outweigh many of these disadvantages.
Businesses that may not want to make the commitment to a cash balance plan or that are not good candidates for it but would nonetheless like to optimize retirement benefits for executive and other highly compensated employees may want to consider a profit-sharing plan with an allocation method known as “new comparability” or “cross-testing.”
With the new comparability plan, profit sharing contributions are allocated using the time value of money as a basis to allocate larger contributions to participants closer to retirement age. Depending on the demographic makeup of a company’s work force, the new comparability allocation method can be an effective means of targeting contributions to certain senior highly compensated employees without committing to funding a defined benefit plan.
Plan design is largely dependent on the demographics of a business as well as the level of contributions with which the business is most comfortable. For these reasons, consulting with a third-party administrator is highly recommended. This third-party administrator will create customized illustrations using your company’s particular demographics to provide alternative plan designs for review and consideration.
Proper retirement plan design can help you fulfill your company’s retirement plan objectives, such as maximizing benefits to key employees, tax deferral and efficient ways to minimize cost to the company.
Matt Gallagher is a partner and head of business development at TrinityPoint Wealth. He can be reached at 203-693-8519 or mgallagher@trinitypointwealth.com.