Cash Balance Plans: $100K to $300K in Pre-tax Contributions
A Cash Balance Plan for small business owners can be one the best ways to shelter large amounts of income from taxation each year. Most small business owners are familiar with 401(K) plans, SEP IRA’s, Solo(k) Plans, and Simple IRA’s, but these “DB/DC Combo” plans bring the tax savings for business owners to a whole new level. DB/DC combo plans can allow business owners to contribute $100,000 to $300,000 pre-tax EACH YEAR which can save them tens of thousands of dollars in taxes. In this article I’m going to walk you through:
How cash balance plans and DB/DC combo plans work
Which companies are the best fit for these plans
How the contribution amount is calculated each year
Why an actuary is involved
How long should these plans be in place for?
The cost of maintaining these plans
How they differ from 401(k) plans, SEP IRA, Solo(k), and Simple IRA plans
The Right Type of Company
When we put one of these DB/DC combo plans in place for a client, most of the time, the company has the following characteristics:
Less than 20 full time employees
The business is producing consistent cash flow
Business owners are making $300K or more per year
Business owner is looking for a way to dramatically reduce their tax liability
Company already sponsors either a 401(k), Solo(k), Simple IRA, or SEP IRA
What Is A Cash Balance Plan?
This special plan design involves running a 401(k) plan and Cash Balance Plan side by side. 401(K) plans, SEP IRAs, and Simple IRAs are considered a “defined contribution plans”. As the name suggests, a defined contribution plan defines the maximum hard dollar amount that you can contribute to the plan each year. The calculation is based on the current, here and now benefit. For 2021, the maximum annual contribution limits for a 401(k) plan is either $58,000 or $64,500 depending on your age.
A Cash Balance Plan is considered a “defined benefit plan”; think a pension plan. Define benefit plans define the benefit that will be available to you at some future date and the contribution that is required today is a calculation based on the dollar amount needed to meet that future benefit. They have caps but the caps are much higher than defined contribution plans and they vary based on the age and compensation of the business owner. Also, even though they are pension plans, they typically payout the benefit as a lump sum pre-tax amount that can be rolled over to either an IRA or other type of qualified plan.
As mentioned earlier, these Combo plans can provide annual pre-tax contribution in excess of $300,000 per year for some business owners. Now that is the maximum but you do not have to design your plan to be based on the maximum contribution. Some small business owners would prefer to just contribute $100,000 - $150,000 pre-tax per year if that was available, and these combo plans can be designed to meet those contribution levels.
Employee Demographic
Employee demographic play a huge role as to whether or not these plans work for a given company. Similar to 401(K) plans, cash balance plans are subject to nondiscrimination testing year which requires the company to make an employer contribution to eligible employees based on amounts that are contributed to the owner’s accounts. But it’s not as big of a jump in contribution level to the employees that many business owners expect. It's not uncommon a company to already be sponsoring a company retirement plan which is providing the employees with an employer contribution equal to 3% to 5% of the employees annual compensation. Many of these DB/DC combo plans only require a 7.5% total contribution to pass testing. Thus, making an additional 2.5% of compensation contributions to the employees can open up $100,000 - $250,000 in additional pre-tax contributions for the business owner. In many cases, the tax savings for the business owner more than pays for the additional contribution to the employee so everyone wins. The employee get more and the business owner gets a boat load of tax savings.
The age and annual compensation of the owner versus the employees also has a large impact. In general, this plan design works the best for businesses where the average age of the employees is much lower than the age of the business owner, and the business owner’s compensation is much higher than that of the average employee. These plans are very common for dentists, doctors, lawyers, consultants, and any other small business that fits this owner vs employee demographic.
If you have no employees or it’s an owner only entity, even better. You just graduated to the higher contribution level without additional contributions to employees.
Reminder: You only have to count full time employees. ERISA defines full time employees as being employed for at least 1 year and working over 1,000 hours during that one year period. If you have employees working less than 1,000 hours a year, they may never become eligible for the plan.
The 3 Year Rule
When you adopt a Cash Balance Plan, you typically have to keep the plan in place for at least 3 years. The IRS does not want you to have one great year, contribute $300,000 pre-tax, and then terminate the plan the next year. Unlike 401(k) plans, cash balance plans have minimum funding requirements each year which is why businesses have to have more predictable revenue streams for this plan design to makes sense.
However, you can build in fail safe into the plan design to help protect against bad years in the business. Since no business owner knows what is going to happen over the next three years, we can build into the plan design a “lesser of” statement which calculates the contribution for the business owner based on the “lesser of the ERISA max comp limit for the year or the owners comp for that tax year.” If the business owner makes $500,000, they would use the ERISA comp limit of $290,000 for 2021. If it’s a horrible year and the business owner only makes $50,000 that year, the required contribution would be based on that lower compensation level, reducing the required contribution for that year.
After 3 years, the company has the option to voluntarily terminate the cash balance plan, and the business owner can rollover his or her balance into the 401(k) plan or rollover IRA.
Contributions Are Due Tax Filing Deadline Plus Extension
The company is not required to fund these plans until tax filing deadline plus extension. If the business is a 12/31 fiscal year end and you adopt the plan in November, you would not be required to fund the contribution until either September 15th or October 15th of the following year depend on how your business is incorporated.
Assumed Rates of Return
Unlike a 401(k) plan where each employee has their own account that they have control over, Cash Balance Plans are pooled investment account, because the company is responsible for producing the rate of return in the account that meets or beats the actuarial assumptions. The annual rate of return target for the cash balance plan can sometimes be tied to a treasury bond yield, flat rate, or other metric used by the actuary within the ERISA guidelines. If the plan assets underperform the assumed rate of return, it could increase the required contribution for that year. Vice versa, if the plan assets outperform the assumed rate, it can decrease the required contribution for the year. The additional risk taken on by the company has to be considered when selecting the appropriate asset allocation for the cash balance account.
Annual Plan Fees
Since cash balance plans are defined benefit plans, you will need an actuary to calculate the required minimum contribution each year. Since most of these plans are DC/DB combo plans, the 401(K) plan and the Cash Balance Plan need to be tested together for purposes of passing year end testing. A full 401(k) may carry $1,000 - $3,000 in annual administration cost each year depending on your platform, whereas running both a 401(K) and Cash Balance Plan may increase those administration costs to $4,000 - $7,000 depending again on the platform and the number of employees.
While these plans can carry a higher cost, you have to weigh it against the tax savings that the business owner is realizing by having the DC/DB combo plan in place. If they are able to contribute an additional $200,000 over just their 401(K), that could save them $80,000 in taxes. Many business owners in the top tax bracket are willing to pay an additional $3,000 in admin fees to save $80,000 in taxes.
Run Projections
As a business owner, you have to weigh the additional costs of sponsoring the plan against the amount of your tax savings. For the right company, these combo plans can be fantastic but it’s not a set it and forget it type plan design. As the employee demographics within the company change over the years it can impact this cost benefit analysis. We have seen cases where hiring just one employee has thrown off the whole plan design a year later.
If you would like to learn more about this plan design or would like us to run a projection for your company, feel free to reach out to us for a complementary consult.
About Michael……...
Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.
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