There’s a reason why cash balance plans are home runs for most of our clients. But that’s not to say they are a great fit for everybody. There certainly are some downsides.
Getting $300,000 a year in tax-deferred contributions can make a lot of sense. But there are a few strings attached.
We’re going to discuss how these plans work and help you decide if these plans are a good fit for you.
Here are the downsides to cash balance plans:
- Permanent design and mandatory contributions
- Higher plan administration fees
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Some background
Cash balance plans are particularly advantageous for high-income business owners due to their ability to provide substantial tax deductions and accelerated retirement savings. These plans offer significant tax benefits, allowing owners to contribute large sums annually, which grow in a tax-deferred account and are deductible in the year contributed.
For high earners making $300,000 or more, cash balance plans present an opportunity to maximize income-tax savings, making them an attractive option for those looking to optimize their tax liabilities. The lure of these plans lies in their ability to accelerate tax-deferred savings, providing a powerful tool for high-income individuals seeking to build substantial retirement funds while minimizing their tax burden.
Now these plans are great for most high income, business owners, there are several downsides to consider. We will walk through the top three and let you decide if a plan is still a good fit for you.
Plan Permanency
First of all, they are permanent plans. What does that mean?
With a permanent plan design, the theory is that these plans will be in place throughout your life and into retirement. This being the case, you don’t have to have the plan forever. But you do want to go into it with long-term and tent. Assume that you will have the plan open indefinitely, and if circumstances change, you can terminate the plan.
The IRS has a say in this matter. They don’t want you to set up a plan one year, terminate the following year, and then set up another plan a couple of years down the road and repeat the process. They want you to have these plans as a commitment.
In a permanent plan design like this, contributions in one year affect the following year. So, there will be ongoing minimum and maximum funding levels allowed.
But don’t let the permanency issue dissuade you from setting up a plan entirely. These plans can be structured to minimize your desired contributions or maximize them if that is your goal. Either way, it all comes down to plan design.
High Administration Fees
Fees are always one of the downsides to these plans. Many people assume that these plans are very unexpected. Inexpensive, like a 401(k) or a set.
But remember, these plans required an actuary to sign off on schedule SB. This is costly. As a result, you’ll see that these plans usually cost a couple of thousand dollars to set up an annual administration fee of at least $2,000 or so.
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Remember that these fees are tax deductible because these plans are company-sponsored. So they are ordinary, necessary business expenses.
In addition, there are no other retirement plans in the market where you can get such significant tax-deductible contributions. So typically, when you look at the cost versus the plan benefits, you’ll find that the benefits undoubtedly exceeded the plans’ price, especially when considering the tax deductibility of plan fees.
You certainly can check around and go with a low-cost provider but expect to pay at least a couple of grand a year to complete your administration. So, ensure you can get a reasonable $50k to $75k contribution in addition to the 401(k) so that the fees will make sense.
Mandatory Contributions
The nice thing about solo 401(k)s and other retirement plans is that they are elect elective as a general rule. So you’re not required to fund them on a given basis.
The fact that they are elective gives you added flexibility to not fund in a year with a high tax burden and to max them out in a year in which you really need the tax deduction. Flexibility is essential.
Because cash balance plans are defined benefit plans and have a permanent plan design. These plans will generally require mandatory contributions. Again, there are ways to control these contribution levels, but expect to have a mandatory minimum.
In many situations, DB plan rules allow plans can be overfunded, which means, in reality, you won’t have a minimum contribution. But these plans can be custom-designed and have various investment returns, so make sure you set aside enough money for mandatory minimums.
Is a Cash Balance or Defined Benefit Plan Right For You?
Final thoughts
Cash balance plans offer predictability and cost efficiency compared to traditional defined benefit plans. The structure of these plans, communicated in terms of an “account balance,” makes the benefits more easily understood and appreciated by employees, enhancing transparency and employee satisfaction.
Overall, cash balance plans serve as a valuable tool for high-income business owners looking to maximize tax deductions, accelerate retirement savings, and provide a transparent and secure retirement benefit structure for themselves and their employees.
But they are not without downsides. This article has noted several downsides with these plans. This includes higher fee structures, plan permanency, and mandatory contributions. While in most situations these are not dealbreakers, this highlights why they’re not great plans for everyone. But not considering these 3 concerns would be big mistakes.
