Tax loopholes do exist. They are just hard to come by. How much do you know about the cash balance plan tax deduction?
When it comes to tax planning, the goal is to take advantage of all legal tax benefits and deductions. But this can be a challenge because many CPAs just don’t do a lot of planning.
In this post, we will highlight why these pension plans are our #1 tax strategy. We will also point out some tips and tricks along the way to make sure you get the maximum benefit. Here is a quick summary and then we will dive in.
Are cash balance plan contributions tax deductible? Here are the deduction strategies:
- Front loading a plan can help you accelerate the tax deduction. But each dollar you contribute upfront is one less dollar you can contribute in future years.
- Plan contributions are allowable when qualifying for Section 199 (QBID) and the pass-through deduction. Based on your funding range, you can contribute an amount to fall below the threshold.
- For a one-person plan, you can combine with a Mega Backdoor Roth. Unfortunately, it rarely works when you have many employees.
- Most clients combine a cash balance plan with a 401(k) plan. This is a common structure for over of our plans and will allow for maximum flexibility.
- There are many tax planning strategies involving a spouse and children that can enhance funding levels when faced with a high tax bracket. These structures also allow for wider ranges and higher contributions.
Table of contents
- Cash balance plan tax deduction limit
- Are they qualified plans?
- What are the tax benefits?
- What about some strategies?
- Are cash balance plan contributions tax deductible?
- Using a plan under section 199 for a 20% deduction
- Employers who may benefit most from cash balance plans
- How to take the tax deduction
- Our 5 favorite cash balance plan tax deduction strategies
- What are the tax deduction deadlines?
- Final Thoughts
Cash balance plan tax deduction limit
Are cash balance pension plan contributions tax deductible?
Yes, they are. Because a cash balance plan is a type of qualified plan, any contributions tax-deductible business expenses. The plans also generally receive favorable creditor asset protection.
So, what is the IRS deduction limit? The IRS allows a maximum contribution that a business owner can deduct of up to 150% of the current accrued liability. This limit is calculated at the actuarial valuation date and includes interest through the plan year-end which normally coincides with the company’s year-end.
These plans have many pros and cons. One of the biggest advantages of a cash balance plan is the ability to defer taxes on the annual contributions. Tax deferral simply means you elect to defer paying taxes on the amount you contribute to the plan.
While most retirement plans have limits on how much you can contribute, a cash balance plan has a relatively higher contribution limit. This allows you to defer taxes now until you are in a lower tax bracket at retirement.
Cash balance plans offer significant contributions like traditional defined benefit plans. However, accounts are presented as a “cash balance”, which makes it easier for employees to understand. This greatly enhances transparency.
Are they qualified plans?
The IRS considers cash balance plans “qualified” plans. This means that they are specified in Section 401(a) of the Tax Code. This allows the contribution to be deductible by the self-employed, including S-Corps, C-Corps and partnerships. A qualified CPA should have some insight into cash balance plans and where to deduct them on your tax return.
Qualified plans come in many different shapes and sizes. This includes 401(k) plans, defined benefit plans, profit sharing plans, SEPs, SIMPLE plans and other pension plans. Contributions are tax deductible because a cash balance plan is technically a defined benefit plan.
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So if you are looking for a retirement plan that will allow for significant contributions along with tax deductions, a cash balance plan may make sense.
What are the tax benefits?
Cash balance plans have become increasingly popular, especially among small business owners and high-income earners. Why? One of the biggest strategies for saving money as a small business owner or high-income earner is through tax deductions.
The higher contribution limits allowed by a cash balance plan give high income earners and small business owners the ability to deduct more from their income, thus saving them in taxes.
The newest tax laws passed in 2017 and effective on January 1, 2018 have raised the marginal income tax rate for households filing jointly up to $600,000. Rates on portfolio income and long-term capital gains have remained the same.
While these increases in high income tax rates are beneficial, they still have their limitations, causing high income earning individuals and families to turn to cash balance plans as a way of saving more money on taxes and heavily funding their retirement.
What about some strategies?
Like most defined benefit plans offered by employers, cash balance plans are considered tax deferred retirement vehicles. Plan contributions are taxed when withdrawn.
The problem with most other defined benefit plans such as a 401(k) plan are the contribution limits. The maximum deductible contribution is limited to $19,500 (as of 2020) for a 401k plan.
The benefit of using a cash balance plan is the ability to contribute substantially more to a qualified retirement pension plan. Contribution limits are age dependent, allowing older aged employees to contribute more. The plan documents will define the contribution limits.
Cash balance plans are unique in that they allow one to contribute to both their cash balance plan and a 401(k) plan. Thus they can take advantage of the tax deduction benefits of both retirement vehicles.
The annual contribution limits to a plan are also dependent upon the number of individual business owners. This includes principals and/or key individuals of the company. This makes the plan very attractive for businesses established as partnerships and companies. They can have multiple levels of ownership and different compensation plans.
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Contributions are deposited into a trustee-directed account. This leaves the responsibility of investment risk up to the plan sponsor, or the investment firm appointed by the small business wishing to offer a cash balance plan.
The employer contributions to the plan also include interest credits. These interest credits are usually between 3% and 5% annually. Depending on how well investments in the plan perform, the minimum requirements concerning deductible contributions may vary each year.
Are cash balance plan contributions tax deductible?
Yes, they are. Businesses are engaging new strategies to ensure maximum tax reduction on their contributions. Partners, S corporations or sole proprietors are enjoying the new 20% tax deduction meant for pass-through businesses.
This rule, however, does not apply equally to all business owners. They, therefore, have to resort to other strategies meant to reduce their business taxable income for them to benefit from the tax deduction. Small businesses can achieve this by making maximum contributions to the traditional pension accounts while higher income companies have to strategize on reducing their taxable income to avoid high taxes.
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Partnerships, S corporations, and sole proprietorships can now make a deduction of 20% from qualified business income thanks to the 2017 tax reform legislation. The legislation, however, denies full benefit for service businesses like accountants, doctors or attorneys if their business owner’s taxable income goes beyond a set threshold amount.
What is the threshold?
The threshold amount for the year 2018 is $157,500 for single filers and $315,500 for a filer and their spouse plus $50,000 for an individual filer and $100,000 for joint filers. Any business owner with more than $207,500 or 415,500 jointly does not enjoy the 20% deduction. They have to ensure that they reduce their taxable income in order to be part of the deduction and save on tax.
Maximizing contributions towards a retirement account is the simplest way for business owners to minimize taxable income. 401(k) plans allow up to $57,000 maximum contributions and an extra $6,500 catch up contributions for 50 and above years.
Cash balance plans are the best retirement plans and significantly reduce the taxable income. Cash balance plan combines the characteristics of a traditionally defined benefit pension plan and a defined contribution plan.
Using a plan under section 199 for a 20% deduction
However, the tax effect of a cash balance plan is on general business income and not at an individual level. The tax deduction benefit is therefore split among business owners.
The non-discriminatory rule also requires that the business owner should contribute to other low income earning employees. This may be a challenge if the business does not generate stable income over a given period of time to sustain the cash balance plan.
Contributions towards public charities and certain private foundations are also deductible for tax purposes subject to AGI limits. Tax legislation of 2017 increased AGI limit from 50% to 60% for 2018-2025 years. Businesses can, therefore, make higher contributions to ensure reduced taxable income.
The 20% deduction is a significant tax saving tool that should be utilized by any business owner. Pass-through entities should ensure that their incomes fall under qualified business income (QBI) for them to enjoy the tax saving strategy. Retirement contributions, mainly a combination of a cash balance plan, 401(k) plan, and a profit sharing plan coupled with charitable participation ensures that business income stays within the threshold limits.
Employers who may benefit most from cash balance plans
The following are some ideal candidates for cash balance plans:
- Accountants, physicians, financial services firms, engineers and consulting firms
- Companies with sustainable above average incomes
- Small business owners of older age and limited retirement funds
- Companies wishing to attract and retain key employees vital to company growth and operation
- High income earners looking to take advantage of tax deductions and retirement pension benefits
With the high taxes and retirement contribution restrictions placed on high income earners, cash balance plans make for an attractive vehicle. You can pay less in taxes and save more for retirement.
|Advantages ✅||Disadvantages ❌|
|Eligible under Section 199 (QBID)||Mandatory contribution levels|
|Flexible min/max funding||High administrative fees|
|Front loaded tax-deductions||Conservative investment yields|
|Tax-deferred investment growth||Complex plan design|
How to take the tax deduction
Five steps to get a cash balance pension plan tax deduction:
- Make sure that the plan is in place before the deadline
This step is important. The plan needs to be established before you file your tax return for the prior year, with the latest date being Sept 15th. You need to also allow yourself enough time to get your custodial investment account set up and funded. You should allow yourself at least a month to get this all completed.
- Determine marginal tax savings
Review your marginal federal and state tax rates to determine how much tax you deferred. The review should address your marginal tax rate rather than your overall effective tax rate. Pay attention to current or pending tax law changes that can impact your calculation. Also, make sure you address the tax bracket because your deduction may impact lower tax brackets. Your CPA can certainly help you address your situation.
- Fund the plan
This step seems easy, but many people will procrastinate. You should coordinate with your financial advisor to make sure your account is established, and your investment allocation is in place. Unfortunately, once the pension plan is set up, it becomes permanent, and not funding the plan is a big problem.
- File your tax return
Now that the hard part is done, you just have to file the return to take advantage of the deduction. You should have a tax professional help you. You will need to communicate the plan to your CPA and should also share your plan documents with them. They may also request to see confirmation of the account funding in order to give you the tax deduction on your tax return.
- Complete five-year plan funding
Lookout at the next five years and try to estimate your tax rates and the related savings. You may need to consider potential tax law changes in your analysis. This way, you can manage your plan to ensure that you are not overfunded or underfunded.
Our 5 favorite cash balance plan tax deduction strategies
Now that you have an excellent overview of some of the tax benefits, let’s talk a little bit about our favorite strategies:
Front loading a plan
As discussed, when you set up a plan, you could include prior service or past service. This allows you to get a higher contribution in your one. This is great if you’ve got a high-income year or expect your income to decrease over the next couple of years.
This might not be the best strategy if you have a consistent income because it can reduce future contributions. But if you have a sizable increase in income for the current year, this is one of our favorite strategies.
The combo plan
You probably know by now that you can combine the 401(k) with a cash balance plan. We do this on probably 80 to 90% of our plan structures. The main reason is that it allows you to contribute larger amounts in high-income years and not fund the 401(k) in years with smaller income.
In addition, administering a 401(k) is simple and affordable. You just have to file a 5500 when the combined balances are over 250,000, and cross-testing is relatively simple. So there are very few reasons not to combine with the 401(k) unless you feel comfortable with the prescribed cash balance plan or funding level.
The QBID or section 199 deduction
Thanks to recent tax reform, you can use a cash balance plan, a deduction for qualifying for QBID, and the 20% pass-through deduction. When you combine with the funding, flexible funding level, you’re able to contribute just the right amount to make sure you fall within the prescribed range.
Even if you are a professional service business, You still can use this to fall within the lower prescribed range, so you don’t hit the phaseouts. Remember to bid is indexed annually by the IRS, so you must use the applicable information for the given year.
The SEP combo
Well, not exactly our favorite strategy, but you still can combine a cash balance plan with a SEP to further improve the tax deduction. However, it can only be a non-model SEP and not a model SEP completed using form 5305.
You’re usually better off using a solo 401(k) rather than a SEP. However, except falls in the IRA family and does not require form 5500 filings. So it can save you the hassle of the fees associated with the 5500. Still, it will only allow you to have marginal additional contributions because you’re limited to 6% of deemed wage, similar to a 401(k) profit-sharing plan.
Mega backdoor Roth
Many people have not heard of the Mega Backdoor Roth. But you can use a cash balance plan. With a mega back door, Roth, assuming you don’t have only a solo plan. You just can’t make it economically work when you have employees.
Now you don’t get the tax deduction with the Mega. It allows you to get tens of thousands of dollars into a Roth potentially. If especially if you are young, this will give you tax-free income upon retirement and is an excellent structure with the cash balance plan.
What are the tax deduction deadlines?
There are a few deadlines of the cash balance plan you will want to keep in mind. Contributions must be made by the tax return due date. But if an extension is filed it is due by the extended due date of the return.
The required minimum funding contribution must be made at least within 8 ½ months following the plan year end. This cannot be any later than the last day of the tax year for a cash balance pension plan tax deduction.
Let’s face it. The main reason someone is investing money into a cash balance plan is to take tax deductions. Cash balance plans have the ability to include contributions that are me several times greater than 401K plans. This is great for the self-employed.
Another advantage is the funding deadline. You have up to the date you file your tax return (including extensions) to fund the plan. But don’t forget to share the details of your plan with your CPA. You don’t want to miss out on the tax deduction.
The use of cash balance plans is becoming quite popular, especially in combination with a defined contribution plan. Benefit illustrations for cash balance plans can clearly illustrate the pay credits allocated to each participant.
These pay credits are usually similar in amount to the plan sponsor’s contribution to the plan. For any benefit illustration, it is essential to provide the assumptions and give some idea of how the results would change based on different assumptions.
Hopefully, this article will give you an overview of our favorite tax deduction strategies. We have been using these plans for over ten years and structuring them for maximum tax benefits.
But everybody’s situation is unique. The best thing that you can do is discuss your plan structure with your CPA and financial advisor. Once you understand your tax bracket better, you’re in a better position to decide which strategy works best for you.
These plans can be complex to understand. But once you have a structure in place, you might find that they are the best retirement strategy on the market.