Many people believe cash balance plans or defined benefit plan structures don’t work well for young people. This is typically because of the lower contribution levels.
I would generally disagree.
While older people get larger contributions, there are plenty of reasons why plans can make a lot of sense for young people. In this post, I will examine some key aspects of these plans. I will then address 5 reasons why young business owners should consider these plans. Let’s dive in!
Most people understand that cash balance plan contributions are primarily driven by age and income. The older you are, and the more money you make (or the higher your W-2 is), the more you can contribute to the plan.
Why do the contributions vary so much based on age? Well, it speaks directly to how defined benefit plans work.
First of all, a defined contribution plan is driven by annual limits. Once you put the money in, it doesn’t matter if it goes up or down because the limits are established each year.
But a defined benefit plan works a little differently. The actuary is trying to determine a benefit at a retirement date in the future. There could be two different people who have the same income.
As a result, they may have the same benefit upon retirement. It’s just that the younger person is a lot further from retirement than the older person.
The younger person simply has more investment compounding. As a result, the contributions don’t need to be so high in order to reach the same benefit as the older person.
How Does Age Disparity Work?
For example, a 30-year-old person with a W-2 wage of $200,000 can only get around $100,000 into a plan. This is approximately 50% of the W-2.
However, a 60-year-old can get in around $240,000 with the same $200,000 W-2. That’s about 120% of the W-2.
The 30-year-old has over 30 years until retirement age. As such, the investment gains, dividends, and interest will compound over time. But a 60-year-old is essentially at retirement age, so they can make substantial contributions because their final benefit is right around the corner.
How do I define a young person? Contribution levels start to make get a little bit larger once someone reaches their mid-40s.
However, for purposes of this article, when I am speaking of a young person, I’m really talking about someone under the age of 40. Here are five main reasons why a cash balance plan can make a lot of sense for a young person.
#1 – Time Value of Money
First, it’s important to understand basic time value of money principles. Remember that you may only have your defined benefit plan open for five or ten years. At some point in the future, it is likely that you will terminate your plan and roll it over into an IRA.
Why would you terminate your plan? Well, the younger you are, the more job changes you may have ahead of you.
For example, you may be working as an independent locums physician today. But in a couple years, you may take a job working for a hospital or small physician group. It’s tough to predict the future.
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Any contributions you make at a younger age will grow tax deferred over a long period of time until retirement. This compounding effect makes those contributions at a young age that much more important.
I’m not going show you a bunch of fancy charts that will show retirement income compounded over time. But let’s just say if a 30-year-old has $100,000 in savings, that could potentially be $500,000 by the time they retire. I think you get the point.
#2 – The Tax Bracket Gap
Second, you need to consider the current tax benefits. The whole reason that tax deferrals make sense is that you’re taking the deduction in a year when you have a large taxable income and are in a large tax bracket. Then you would draw the money out at retirement when you’re presumably in a lower tax bracket.
Most of our clients have an average tax bracket of around 40%. But they may possibly be in a 20% tax bracket when they retire.
Many people believe that tax rates are only going up. This might be the case. However, tax brackets typically go up at the high end of the income range.
For most people who make $100,000 or even $200,000 a year, the income tax rate is usually not that bad. This is typically where you’ll be in retirement.
So, it’s pretty clear that you want to take advantage of as many tax deductions as possible when you’re in that high tax bracket.
#3 – Starting the years of service clock
We have mentioned that these plans contributions are largely driven by age and income. But the actuary also considers years of service.
Said differently, the benefit starts to increase for each year a person is employed with the company. In addition, as the accrued benefit grows, the IRS allows deductibility of up to 150% of the accrued benefit.
So, starting early can start to build a large range between the minimum, maximum, and target contribution. This gives a wider range and can add more plan contribution flexibility as someone gets older.
#4 – Annual administration fees are tax deductible
Of course, a big reason people say that young people should not have a defined benefit plan is because the administration fees are substantially higher than a 401(k). This is certainly the case that the fees are substantially higher.
But remember, these plans are company-sponsored plans. As a result, the fees are tax-deductible to the business. If your annual fees are, for example, $2,000 a year, with a 40% tax bracket, it’s only like paying $1,200.
#5 – The “feel good” factor
Lastly, there’s something I call the feel-good factor. We just feel better when we have more money in retirement.
For example, I think you would feel better if you had $2 million in retirement compared to $1 million. You would sleep better at night.
This is pretty basic. But obviously, many financial decisions, will come down to how it makes you feel.
As a CPA, I was always confronted with clients asking me about different financial situations and what they should do. Very often, the financial decision could go either way.
At the end of the day, I would ask the client which strategy helps them sleep better at night. This sometimes is more important than actually making the technically “smart” decision. Of course, I always try to steer clients away from bad financial decisions that were clearly not in their best interest.
You don’t control the future. The future always has some uncertainty. In fact, you never know if defined benefit plans will be outlawed at some point in the future. I doubt that will happen. But you never know.
It is crucial for young people to start saving for retirement early on. The power of compounding and long-term investment growth cannot be underestimated.
By starting early, young individuals can take advantage of the time value of money. Moreover, with increasing life expectancies and uncertain economic conditions, it is wise to start contributing to retirement plans as early as possible.
In addition, saving for retirement at a young age instills valuable financial discipline and habits that can benefit individuals throughout their lives. It encourages responsible financial planning and wise money management, enabling young people to develop a strong sense of financial security and stability.
Ultimately, by embracing the importance of saving for retirement, young people can pave the way for a financially secure future and enjoy the freedom to pursue their passions and dreams without being limited by financial constraints.