Running a business or working in a field with fluctuating income, such as litigation or commission-based roles, presents unique challenges for retirement planning.
A key question many business owners face is how to manage their cash balance plan when their income is highly volatile. This article addresses the strategies you can implement to ensure your retirement plan remains on track, even with an inconsistent income stream.
Undoubtedly, defined pension plan contributions can be slightly more challenging when someone’s income is volatile. It is tougher to plan for contributions with such wide income swings.
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Understanding Volatile Income and Retirement Plans
Volatile income is common in fields like law, real estate, and freelance work. In these professions, some years may be highly lucrative, while others bring in little or no revenue. This variability can make retirement planning difficult, particularly when it comes to defined benefit plans like cash balance plans. Unlike traditional savings accounts, cash balance plans require ongoing contributions, which can be tough during lean years.
Cash Balance Plans vs. Defined Contribution Plans
Cash balance plans are a type of defined benefit plan, which differs significantly from defined contribution plans like 401(k)s or SEP IRAs. Cash balance plans offer several advantages, particularly for business owners with high incomes, but they also require careful management:
- Flexibility: Cash balance plans offer more contribution flexibility compared to defined contribution plans, allowing for large contributions in profitable years.
- Tax Efficiency: Contributions to cash balance plans are tax-deferred, providing substantial tax savings, especially during high-income years.
- Retirement Security: While these plans are long-term commitments, they provide predictable retirement benefits.
The Long-Term Nature of Cash Balance Plans
One crucial aspect to remember is that cash balance plans are long-term retirement vehicles. Even if your income fluctuates from year to year, you need to look at your plan with a broader, multi-year perspective. These plans are typically meant to last anywhere from 5 to 20 years, with consistent contributions over time.
Because of this long-term outlook, you should not judge the success of your plan based on a single year of income. The key is to maximize contributions during high-income years and minimize contributions during low-income periods.
Front-Loading Contributions in High-Income Years
Front-loading contributions—contributing the maximum amount possible during years when your income is high—can be a highly effective strategy for managing your retirement plan. This strategy allows you to:
- Maximize Tax Benefits: Large contributions during high-income years provide significant tax deferral benefits.
- Build Up Plan Assets: By contributing more when you can, you create a cushion for low-income years.
For example, if an attorney earns $3 million in a good year, it makes sense to contribute the maximum to the cash balance plan in that year. In contrast, if the following year brings in little or no income, contributions can be minimized.
Example: Attorneys with Variable Income
Many attorneys, especially those working in litigation or on contingency, experience significant income volatility. In these cases, front-loading during “feast” years and cutting back in “famine” years can lead to effective long-term planning. For example:
- Year 1: An attorney earns $3 million. Contribute the maximum allowable amount to the cash balance plan.
- Year 2: The attorney earns $100,000. Focus on maxing out contributions to a 401(k) or profit-sharing plan and contribute minimally to the cash balance plan.
- Year 3: The attorney earns $3 million again. Contribute the maximum to the cash balance plan.
By alternating between high and low contribution years, you maintain the plan’s health while taking full advantage of tax benefits during high-income years.
Minimizing Contributions During Low-Income Years
During low-income years, it may not be financially feasible or tax-efficient to contribute a large sum to your cash balance plan. Instead, you can:
- Focus on 401(k) and Profit-Sharing Plans: In low-income years, maxing out your 401(k) contributions or utilizing a profit-sharing plan can still provide tax advantages without overburdening your cash flow.
- Apply the “31% Rule”: This rule allows you to make a smaller contribution, typically around 31% of your previous high-income year’s contribution, keeping your plan compliant while minimizing outlays.
Managing Administration Costs in Low-Income Years
One downside to maintaining a cash balance plan is the ongoing administration cost. Even if you don’t make significant contributions in a low-income year, you’ll still need to pay for plan administration. While this may feel burdensome, it’s crucial to view this expense as part of the long-term strategy.
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When viewed over a 10-year horizon, the benefits of front-loading contributions during high-income years typically outweigh the administrative costs incurred during low-income periods.
The 10-Year Strategy for Cash Balance Plans
To manage a cash balance plan effectively, especially with volatile income, you need to think long term. Here’s how a typical 10-year strategy might work:
- Max Fund in High-Income Years: Contribute the maximum allowed by the IRS in years when your income is strong.
- Minimize in Low-Income Years: Cut back contributions in low-income years, focusing instead on other tax-efficient plans like 401(k)s.
- Evaluate Over the Long Term: Look at the total benefits over a 10-year period, not year-by-year. This approach provides more flexibility and maximizes your retirement savings over time.
Although volatile income may cause hesitation, cash balance plans are structured in a way that makes them advantageous for those experiencing income fluctuations. The ability to contribute large amounts in profitable years, combined with the long-term benefits of the plan, ensures that you can accumulate significant retirement savings despite year-to-year variance in income.
Strategic Flexibility in Cash Balance Plans
One of the biggest advantages of cash balance plans over defined contribution plans is their flexibility. These plans allow you to adjust your contributions based on your income each year.
- High Income: Max out your contributions to lower your taxable income.
- Low Income: Focus on 401(k) and profit-sharing plans while contributing a minimal amount to the cash balance plan.
For those with variable income, a “feast and famine” approach can be highly effective. During the “feast” years, front-load your contributions to the cash balance plan. During the “famine” years, minimize contributions while maintaining the health of your plan for the future.
The Role of an Actuary in Managing Volatile Income
An actuary plays a crucial role in managing your cash balance plan, particularly in volatile income scenarios. The actuary will help you adjust your contributions to ensure your plan remains funded, even if your income fluctuates dramatically from year to year. They also assess the health of your plan and make necessary adjustments based on the assets and future liabilities.
Given the complexity of managing a cash balance plan with volatile income, ongoing consultation with financial advisors is essential. Tax planning, contribution strategies, and long-term projections should all be part of your retirement planning process.
Is a Cash Balance or Defined Benefit Plan Right For You?
Why Cash Balance Plans Still Make Sense for Volatile Income
In conclusion, while income volatility may seem like a barrier to using a cash balance plan, the reality is that these plans offer considerable flexibility and long-term benefits. By front-loading contributions in high-income years and minimizing them in low-income years, business owners can maintain a healthy retirement plan and maximize tax advantages.
