How to ‘Legally’ Structure a Self-Employed Cash Balance Plan [Video]

So, you thought tax loopholes went away with tax reform? Not so fast. There are a few loopholes left for the self-employed.

One of our favorites is the cash balance plan. The benefits to business owners are pretty clear. However, prior to establishing any plan, make sure that you understand the advantages and disadvantages. In this article, we will take a closer look.

What is a self-employed cash balance plan?

A self-employed cash balance plan is actually a defined benefit pension plan. It has a similar structure and design of a traditional defined benefit plan, but with more flexibility. A cash balance plan allows for significant tax deductible funding that can be rolled over into an IRA upon retirement.

When people first think of retirement structures, they typically consider a 401(k) or a SEP. These plans are excellent options, but the allowable contributions are just too low for high income business owners. A cash balance plan can allow contributions as high as $300,000+ annually.

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A cash balance plan simply states that the employer will contribute a percentage of your yearly salary plus an interest credit to an account designated for retirement. The interest credits are usually between 4% and 5%.

In a cash balance plan, your money is set aside into a “hypothetical account” for the named employee.  This account is not the same as an employer’s trust account for its employees, but rather is pooled together in one account for all employees with the designated amount for each employee.

What self-employed businesses qualify?

On average, most small business owners will be able to make annual contributions over $100k. These contributions are tax-deductible and grow tax-deferred. These plans will allow significantly higher contributions than a solo 401k or SEP. 

Cash balance plans are technically defined benefit plans.  The rules are governed by the requirements and limitations of defined benefit plans. But cash balance plans really function more like a “hybrid” plan (which is their nickname). This means that they are a combination of defined benefit plans and defined contribution plans (401ks for example).

Looking for more information on cash balance plans? Take a look at our ultimate guide to cash balance plans. Discover our favorite strategies!

The small business plan for the sole proprietor or S-corp

Under a traditional cash balance plan, the employer will credit a participant’s account balance with a specific percentage of his or her annual compensation. In addition, the account will get an interest credit.

Changes in the actual investment accounts will not impact any final benefits received by the participants. The company itself will bear the ultimate risk of investment returns in the portfolio.

Scrabble pieces spelling TAX

Contributions to cash balance plans are based on actuarial assumptions. This will ensure that the plan will provide adequate benefits to plan participants at retirement age. The actuary must use specific assumptions and calculations to ensure proper contribution levels.

Once initiated, the company must continue to make annual contributions until the plan is terminated or frozen. Large companies will set-up plans for long periods. However, many small employers terminate plans during the first 10 years of inception.

If you are setting up a cash balance plan for self-employed, make sure that you do plenty of diligence to make sure that you understand the plan requirements and have the financial ability to fund the plan for an ongoing period of time.

What about the contribution limits?

Like most retirement benefit plans and other individual retirement account plans, there are limits as to how much you can contribute on a yearly basis. For cash balance plans, those limits are not subject to the yearly contribution limit that traditional defined contribution plans abide by.

The yearly contribution limit of a cash balance plan are age dependent, meaning the amount you can contribute depends on how old you are. The reason for this rule is because an older person has fewer years to save, giving them a smaller advantage in the amount that they can contribute.

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The plan document will specify how much that contribution limit is. The plan document includes the contribution formula.

Does a cash balance plan for the self-employed require the same contribution to each employee?  No. The plan has the ability to pay different credits for different groups of employees. As such, the different groups may be defined by things such as age, service, area of operation within the company, and ownership percentage.

Cash balance plan small business

Does the IRS consider a cash balance plan a “qualified” plan? Yes. A qualified plan indicates that the plan has designated tax benefits. Also, it grows tax free, and contributions aren’t taxed until withdrawal. Most qualified plans include other benefits such as bankruptcy protection and flexible rollover options.

Cash balance plans are based on actuarial calculations with numerous assumptions. These assumptions may allow flexibility in funding a plan, which can be overfunded in a given year. This will lead to lower funding levels in the future. However, a business owner can make significant contributions to reduce taxable income, therefore reducing the tax liability.

Cash plans have a significant advantage over other traditional types of pension plans. Cash balance plans have interest rates; the returns can be predicted more efficiently, giving business owners greater peace of mind.

Custom Plan DesignMandatory Contributions
Tax-Deferred GrowthExpensive Admin Fees
Contributions > $300,000Permanency Requirement
Self-Directed AssetsComplex Plan Structure

How to structure a cash balance plan for the self-employed

Here are five steps to consider when setting up a cash balance plan:

  1. Run an illustration detailing contribution levels

    The first step is to select an administrator that you believe is qualified and have them run a few illustrations. These illustrations are usually free. So make sure that you consider various funding levels and plan designs. There are many ways to structure these plans and the first step is the illustration.

  2. Consider a 401(k) combo

    Small business owners can combine these plans with 401(k) plans to allow for larger contributions. There are a few restrictions. The restrictions are small compared to the larger contribution levels. But realize that cash balance plans do not combine with SIMPLE IRAs and many SEPs.

  3. Consider prior service adjustment

    In the first year, you have the ability to structure the plan to give a credit for any employee (including yourself) who provided services in prior years. With this approach, you can make a large, front-loaded contribution in year one. This works great if you have higher than normal taxable income in year one. But it will pull contributions from future years, so you should carefully consider.

  4. Run a 5 year projection

    These are permanent plans. As such, you should plan on keeping them for a minimum of 3 years. Our average client has them for approximately seven years. Take a look at your expected funding over a five year period and see if the plan makes sense for you.

  5. Coordinate with your CPA

    The CPA is often the gatekeeper for these plans. They can review illustrations and prepare a tax analysis. Once you know your tax bracket, you can run a sensitivity analysis to determine the tax impact based on different funding levels.

Final thoughts

The above strategies can achieve maximum owner contributions, but IRS rules must be followed. If properly structured, a cash balance plan is an excellent retirement strategy.

The important point to note is that self-employed people have plenty of retirement options. Just do your research and choose the best plan for you.

Paul Sundin

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