If you own your own business and don’t have employees, you may wonder how you’ll contribute to or catch up on your retirement accounts. If retirement isn’t too far off, an IRA won’t be enough to keep you afloat during retirement since the contribution limits are so low.
A personal cash balance plan could be a good solution. Here’s how it works and what you must know.
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What is a Personal Cash Balance Plan?
Cash balance plans have a predetermined annual contribution or pay credit and a predefined rate. Unlike a 401K, the balance isn’t determined by an investment’s performance. There is a predetermined rate of return that is what drives investment managers’ decisions on what investments to consider.
At retirement, you can choose to take the funds as a lump sum or monthly payments. The limits for personal cash balance contributions are much higher than an IRA or 401K and depend on your age and goes up to $341,000 for 2022.
How it Works
Cash balance plans have hypothetical account balances. It sounds odd, but it’s based on the predetermined contributions and rate of return. They are not based on the actual performance of individual investments like a 401K.
The business carries the risk of making up the difference in the hypothetical account balance at retirement if the investments didn’t reach their full potential. All funds grow tax-free, and withdrawals are taxed at your retirement tax bracket.
If you choose a lump sum payout at retirement, you can roll it over into an IRA to avoid taxation on the full amount and control how much you receive throughout retirement.
The Benefits of a Personal Cash Balance Plan
Business owners greatly benefit from a personal cash balance plan because you can catch up on your retirement contributions quickly. If you didn’t contribute to your retirement accounts for the last few years while you set up your business, you may feel behind. The cash balance plan allows plenty of room to catch up.
As a participant, you don’t have any risk in how much is in your account at retirement, since it’s the business’s responsibility to make up the difference. Even though you are the owner, it won’t come out of your personal pocketbook, but instead, the business’s value.
Another benefit of the cash balance plan is the tax deductions. All contributions are pre-tax. This means your business avoids tax payment on the funds you contribute to your cash balance plan. Like we said earlier, the funds grow tax-free in your account too. You don’t pay taxes until you withdraw the funds.
If you have a pass-through entity such as a sole proprietorship or partnership, it decreases your tax liability personally since all taxes are passed through to you personally.
Finally, cash balance plans, like 401K accounts, are protected from creditors. This means if you or your business must file bankruptcy, your creditors cannot come after your cash balance plan. You’ll still be set up for retirement.
The Downsides of the Cash Balance Plan
It’s important to understand the good and the bad sides of a cash balance plan. While there are plenty of reasons to consider one, there are some disadvantages including:
- There are strict IRS guidelines and regulations that can get confusing
- Employers face high administrative costs
- The plan could require large contributions which could be hard for the business to afford consistently
Who Should Consider a Cash Balance Plan?
Cash balance plans aren’t right for everyone, but here are some things to consider to decide if it’s right for your company.
- You want to contribute more than $20,500 to your plan. If you need to catch up on retirement contributions, or worry about not having enough for retirement, a traditional 401K plan may not be enough. You can only contribute $20,500 with an additional $6,500 if you’re over age 50 in a 401K. The limits are much higher in a cash balance plan.
- Your company has consistent cash flow. If your company is established and consistently earns profits, it can likely afford to pay the larger contributions toward your retirement. Not only will you set yourself up for the future, but you’ll also reduce your tax liabilities.
- You are ‘older.’ Cash balance plan contribution limits are based on your age. The older you are the more you can contribute and like we said above, the limits can get as high as $341,000, which is much more than a 401K plan allows.
The Difference Between a Cash Balance Plan and 401K
You might wonder what the difference between a cash balance plan and 401K is since they sound so similar.
First, the contribution limits are vastly different. You can contribute much less to a 401K than you can a cash balance plan.
Second and most notably, there’s no guarantee on your 401K balance. It’s dependent on the market’s performance which means your balance and fluctuate considerably. There’s no guarantee you’ll have a set amount of money at retirement.
A cash balance plan has a guaranteed balance which becomes the business’s responsibility to make up the difference if the balance isn’t the promised balance at retirement.
|For Owner Only||Permanent Plan Design|
|Custom Plan Structure||Higher Plan Costs|
|Tax-Deductible Funding||Mandatory Plan Contributions|
|Flexible Contribution Range||Complex Structure|
In addition, employers can invest the cash balance plan funds just like they can invest other defined benefit plan funds. Participants’ retirement accounts grow by earning annual credits based on a flat percentage of pay and could be integrated with Social Security benefits.
In addition, accounts earn an interest credit each year that is tied to some external index, such as the Consumer Price Index or the rate on U.S. Treasury bills. Benefit accrual formulas based on an employee’s career average earnings tend to be more beneficial to employees just beginning their careers than employees who are close to retirement and have worked most of their employment under a more traditional defined benefit plan.
A cash balance plan is worth considering if you are self-employed and don’t have a retirement account or even if you do. If you want to catch up your contributions or ensure you have enough for retirement while decreasing your tax liability, talk to your tax advisor about a cash balance plan.
While it has regulations that can be strict and require more work on your end, it can help you have the money needed for retirement, which is most business owner’s goals in owning a business – setting themselves up for the future.