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 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. Let’s dive in!
Table of contents
Is a plan tax deferred?
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 contributions each year. Tax deferral simply means you elect to defer paying taxes on the amount you contribute to the pension plan.
While most retirement plans have limits on how much you can contribute, 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, 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 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, 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.Looking for more information on cash balance plans? Take a look at our ultimate guide to cash balance plans. Discover our favorite strategies!
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 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.
|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.
- 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.
What are the 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.