What if you could put an extra $100,000 to $200,00 a year into retirement? Cash balance plans for professional practices could do this for you.
While these retirement structures allow big tax-deductible contributions, they can be complex. We’ll discuss what makes these plans so unique.
In this post, we will show you how these plans are structured and give you some insight. The goal is to give you some instruction on plan design the related deadlines.
Let’s dive in!
Some background
Cash balance plans allow owners and partners in professional practices an easy structure to lower taxable income and make large retirement contributions. These contributions will substantially exceed traditional 401(k) profit sharing plan contributions.
Unlike traditional pensions, the money will be available as a lump sum in retirement, hence the Cash Balance. Another good advantage to the Cash Balance plan is that the management of the funds is typically allowed by the employee, much like a 401k.
Various investment choices, such as mutual funds, may be available. Traditionally, pension illustrations were managed professionally by the employer/third party, and participants were just given a formula for an amount of money or income available at retirement.
Cost structures for professional practices
Cash balance pension plans typically give employees 5% to 8% of their yearly salary as employer contributions. Participants also receive interest in the account and, most of the time can choose other investment options, to potentially increase their savings.
In terms of plan costs, cash balance plans can cost more than 401k’s to set up and maintain. Some costs can range from $1,000 to $3,000 in setup fees alone and then thousands in annual fees for annual administration.
There are limits involved with cash balance plans or any defined benefit plans. The limits are more generous than 401k’s and other similar retirement plans. This makes the Cash Balance pension a popular option in later years to help greatly with taxes.
So how do the plans work?
Defined benefit plans are not very common in the private sector. In fact, statistics show that only 4% of workers in the private sector have a defined benefit pension plan. About 14% of private companies have combined defined benefit and contribution plans.
The public sector prefers defined benefit plans, with 88% of employees covered under a defined benefit pension plan. A good reason for this is that the employer contributes to the plan in the private sector and bears the risks associated with overall funding. Accordingly, they may be deemed too risky. But in the public sector, employees can often contribute to their own defined contribution plans.
Defined benefit plans also work well for employers and key employees with high compensation. An annuity is calculated as a percentage of earnings. If the compensation is high, then the retirement benefit is also high. Small employees with small revenues have very few retirement benefits to smile about.
However, we have seen increased cash balance plans for professional practices in recent years. The main reason is that small business owner (including sole proprietors and single shareholder S-corps) have realized that the plans have become a great way to secure their retirement. As long as employee contributions can be minimized, significant personal contributions are possible.
With 401K plans, employees will invest personal pre-tax dollars into the market in anticipation of a decent rate of return. But the risk is on them. In contrast, a defined benefit plan has a regular rate of return that the company monitors and the plan actuary.
Business owners can use a plan to maximize their contributions and retain and reward essential employees. It often acts in place of a bonus subject to immediate income tax. Employees may not see the primary benefit (like a bonus), but they tend to be a key ingredient in employee retention.
So what is the employer’s responsibility?
The employer has many responsibilities when it comes to administering plans. The primary responsibility is to invest the plan assets for the benefit of the employees.
If investment returns are lower than anticipated, the company will be forced to make up for the shortfall. To avoid any complications, the company will need to consider three investment issues:
| Asset diversity | The allocation of plan assets will significantly impact overall plan funding. |
| Interest rate assumptions | Planned and expected interest rates will play a big part in the plan returns. Higher assumed rates might minimize the company’s funding requirements. Conversely, lower rates may require the company to step up funding efforts. |
| Dealing with plan shortfalls | If expected returns are less than anticipated, the company may have to deal with a shortfall as with any investment. This is not the case with other retirement plans that allow for elective contributions. In some situations, shortfalls can be amortized over future years. But this issue should be discussed with your CPA and third-party administrator. |
Our favorite strategies
Include your spouse in the plan
Spouses usually provide support in the business, even on a part-time basis. They should, therefore, be on the payroll and are subject to a 15.3% employment tax. Being on the payroll allows them to receive benefits like any other employee.
Therefore, they can make contributions to a 401k and a profit-sharing plan. Thus, a business owner can contribute to a defined benefit plan for their spouse. However, the spouse should be working for the business.
Hire non-qualifying employees
Another good strategy is to hire employees based on their age and working hours. A defined benefit plan requires that an employee should work more than 1,000 hours and be 21 years or more. Part-time employees and those under 21 years old are, therefore, excluded.
An employer should, however, be careful when using this strategy. Young employees, for example, may lack the necessary business experience. Part-time employees might not have the motivation or commitment.
Don’t forget plan entrance date
The entrance date is when employees can enroll once the service conditions and age requirements are fulfilled. Entrance dates can be monthly, quarterly, semi-annual, or annual.
An annual entrance date will be favorable for business owners wishing to keep transient employees off the plan. It is the most restrictive timeline under the defined benefit plan rules.
Consider a higher wage
Business owners with S corporations benefit from defined benefit plans. They can limit payroll taxes through reasonable owner compensation. They can also avoid double taxation subjected to C corporations.
Contributions to a defined benefit plan depend on age and compensation level. By increasing the W-2 salary, the owner can maximize his contribution. This can also apply to the spouse. However, a high wage translates to higher employment tax and social security contributions.
The social security wage base has limits. Therefore, the 12.4% social security tax cannot exceed this wage. Thus, a business owner can increase wages with minimal taxation increases.
But before doing this, make sure to discuss the reasonable compensation rules with your CPA.
Consider 3 Year Cliff Vesting
Plans can have a 3-year vesting. Cliff vesting is often the favored strategy. It requires participants to be 100% vested after three years of participation. Therefore, no participant is vested until they attain three years of service.
In the case of termination before three years, all the contributions are forfeited. They can then be used to reduce future contributions.
Utilize a life insurance strategy
A defined benefit plan allows for plan assets and future contributions to pay for life insurance premiums for its participants. The life insurance policy will use tax-deductible dollars.
How to structure cash balance plans for professional practices
Here are 5 steps to structuring a plan for your business:
- Consider how much you would like to contribute
If you want to get for example $10,000 to $30,000 into a plan then a 401k might be best. But for contributions in excess of $100,000 a defined benefit plan would be ideal. Have your TPA run an illustration to find out contribution levels for your business.
- Examine your expected business profits
Don’t forget that solo 401k contributions are elective. However, defined benefit plan contributions are not. Take a close look at your business cash flows. If you expect large profits then a defined benefit plan might be a wise choice. If you foresee a slow down or possibly a recession, you may want to consider other options.
- Review plan costs and fee structure
A solo 401k plan is inexpensive to administer. But defined benefit plans are a little more expensive. The higher fees can make a lot of sense if you are contributing significant amounts. Fee structures can vary from administrator to administrator and prices are much higher for larger plans with many employees. Just consider the cost and benefit of each plan.
- Discuss with your financial advisor or tax professional
Do you have a close relationship with a financial planner or CPA? Discuss the issue and consider their recommendations. A tax professional is in a great situation to review your tax rate and offer suggestions. Remember that most financial professionals don’t usually understand how the plans are structured. Cash balance plans for professional practices can be complex, so you will need to allow time to make sure all parties are educated.
- Don’t lose sight of the deadline
Many people forget that the deadline to establish a calendar year plan is before the tax return is filed. This also included extension periods. But make sure not to wait until the deadline because you also need to get investment accounts set up.
| Benefits | Pitfalls |
|---|---|
| Qualified plan status | No employee deferral |
| Typical contributions > $100k | Complex plan structure |
| Significant tax deferral | Mandatory funding requirements |
| Flexible contribution ranges | More expensive to maintain |
Ideal professional candidates
While many businesses in a variety of industries can be great candidates, professional firms are the ones that can benefit the most. Professional service firms usually have fewer employees and higher owner compensation compared to earnings than many businesses. For that reason, they are the best candidates.
Let’s examine a few professional service businesses that can benefit the most from a plan:
- Physicians
- Actuaries
- Psychologists
- Dentists
- Attorneys and law firms
- CPAs & Accountants and CPAs
- Engineers
- Chiropractors
- Architects
Historically, law firms and medical practices have been significant proponents of cash balance plans. An important reason is the consistent high income especially as the owners get older. These professional firms want higher contributions into the owners or partners retirement accounts.
| Features & Benefits | Downsides (Cons) |
| Custom Plan Design | Permanent Structure |
| Flexible Contribution Range | Higher Plan Cost |
| Tax-Deferred Growth | Required Actuary Review |
| Asset Protection | Complex Administration |
Final thoughts
Cash balance plans are fantastic retirement vehicles for business owners. For many, they are one of the best options available. However, they are not for everyone. Older business owners with high, consistent income and few employees are ideal candidates.
Retirement planning is great. But lowering taxes is really what drives professional firms to cash balance plans. When you combine high federal and state tax brackets, these plans become a no-brainer for high income business owners.
