Small business owners are often ideal candidates for one of the best kept secrets in retirement savings: the Cash Balance Plan. Not only does this allow you to reduce your taxes significantly, but it better prepares you for those very expensive retirement years. In fact, as of 2024, you could save up to an additional $275k a year, tax deferred, positioning yourself for a retirement benefit of up to $3.5 million!
Recognize that each situation is unique, however, and it may or may not make sense for you to use a Cash Balance Plan. The value of implementing a plan like this can be measured, usually at no cost. Ask your financial advisor to help you locate a resource for this analysis.
Generally, Cash Balance Plans are worth considering for sole proprietorships, corporations, partnership of corporations, partnerships, closely held businesses etc., if the following apply:
- You are looking for greater tax deductions
- You are already making the maximum contribution to your 401(k) & Profit-Sharing Plan
- You have reliable and adequate income
- You are willing to commit to some level of contribution
- There is a large age differential between yourself and your employees, specifically that you are older
What are Cash Balance Plans? Cash Balance Plans are a type of defined benefit pension plan. That is, they provide for a predetermined retirement benefit, either in the form of a stream of income or as a lump sum. This is distinct from the more common defined contribution plans—for instance, your 401(k), where only the upfront contribution is known rather than the end benefit, as it is dependent on investment performance.
These plans have been available for many years. However, their popularity was slow to gain momentum until 2006, when the Pension Protection Act cleared up some uncertainties regarding these plans. Now, although gaining popularity, it seems to be one of the best-kept secrets here in the Central Valley.
What is so great about Cash Balance Plans?
First, the sizeable tax deduction. In the traditional qualified plan environment such as a 401(k) Profit Sharing Plan in 2024, a business owner is limited to a maximum contribution and therefore tax deduction of $69,000/yr. ($76,500 if you are over 50). A combined Cash Balance plan and 401(k) contribution for an individual who is 60 could be as much as $336,000/yr. This allows people who have waited to save for retirement to infuse their retirement capital and still enjoy the tax deduction.
Second, there are flexible plan design options that can benefit older owners and key employees while potentially limiting the number of employees covered.
Third, this type of benefit can give you a competitive advantage in hiring and retaining quality employees.
What are some of the disadvantages?
First, Cash Balance Plans can be a bit costly to administer. However, when all is said and done, dollar for dollar, it may be well worth it.
Second, you are committed to a certain level of contribution, typically for a three-year period. As such, Cash Balance Plans do not make sense if your cash flow is highly unpredictable from year to year.
Third, the Cash Balance Plan will have a pre-determined guaranteed rate of return, commonly between 3% and 5%. If over a period of time the investment portfolio does not earn that guaranteed rate of return, then a greater contribution would have to be made to satisfy the shortfall. Alternatively, if the plan makes much more than the guaranteed return, the contribution may have to be reduced, and thus, the tax deduction for that year may not be as high as originally anticipated. As such, a conservative investment strategy that reduces overall portfolio volatility while at the same time targeting the required return is optimal.
The ultimate message here is that Cash Balance Plans can be wonderful tools for the right situation and should be considered when creating your financial strategy for retirement.
Written by: Whelan Financial
