As a CPA by trade, I enjoy tax planning with my clients. The goal is to deduct all legal tax deductions. But most importantly, my job is to educate my clients so that they are aware of all legal tax deductions. Let’s look at the cash balance plan tax deduction.
Structuring retirement plans is no different. The goal is to maximize retirement savings and obtain tax deductions at the same time. When it comes to retirement plans it is even more important. The whole goal for a retirement plan is to boost your retirement see a savings and obtain tax deductions. That is the end result. Unless you were investing in a Roth.
Is a cash balance plan tax deferred?
One of the biggest benefits of a cash balance plan is the ability to defer taxes on the contributions each year. Tax deferral simply means you can elect to defer paying taxes on the amount you contribute to the plan.
While most retirement benefit plans have limits on how much you can contribute limiting the amount of tax deductions you can take, a cash balance plan has a relatively higher potential contribution limit. This allows you to defer taxes paid now until you are eligible to withdraw the funds.
Cash balance plans offer significant contributions like traditional defined benefit plans. However, they are presented as a “cash balance” which is easier for employees to understand. Transparency is greatly enhanced.
The cash balance plan tax deduction
The IRS considers cash balance plans “qualified” plans. This means that it is specified in Section 401(a) of the Tax Code. This allows the contribution to be deductible by the self-employed as well as 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, and SIMPLE plans. Contributions are tax deductible because a cash balance plan is technically a defined benefit plan.
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.
Cash balance plan tax deduction: 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.
Cash balance plan tax deduction: What are the tax benefits?
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. Under a regular 401(k) plan, the maximum deductible contribution is limited to $18,500 (as of 2018).
The benefit of using a cash balance plan is the ability to contribute substantially more to a qualified retirement plan. Contribution limits are age dependent, allowing older aged employees to contribute more. The plan documents will defined 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.
Cash balance plan tax deduction benefits
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.
The investment firm in charge of managing the plans investments are responsible for communicating the plan policy, the funding policy and actuarial policies to the sponsoring business so that these minimum requirements are planned well in advance.
Are cash balance plan contributions tax deductible?
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.
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.
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 $55,000 maximum contributions and an extra $6,000 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. The main advantage of a cash balance plan is apart from the employer’s set contribution annually towards the plan, a participant’s account also receives an interest credit every year.
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 include:
The following are some ideal candidates for cash balance plans:
- Accountants, 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 planning 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.
Cash balance plan tax deduction: What are the deadlines?
There are a few deadlines of the cash balance plan you will want to keep in mind. For tax deduction purposes, any contributions to the cash balance plan 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 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.