Throughout our blog series about retirement plans for the self-employed, there has been a lot of “either this or that.” Simple IRA or SEP IRA? Solo 401(k) or SEP IRA? Roth IRA or Traditional IRA? Typically, business owners will choose one type of retirement account for themselves. As we wrap up our series, we’ll summarize the basics of one more retirement plan. This one is different in that it’s often a complement to other retirement plans. It’s called a cash balance plan.
CASH BALANCE PLAN CHARACTERISTICS
Cash balance plans are technically a “defined benefit pension plan.” (There’s actually one other type of defined benefit pension plan and two types of defined contribution pension plans, but we’re not covering those for the sake of simplicity). Here’s how a cash balance plan works:
- The business owner defines what they would like the plan to provide for the participants. For 2024, the maximum benefit is $275,000 or 100% of the participant’s average compensation over the highest three consecutive years, subject to age and service adjustments. This is where you get the term “defined benefit.” You start by defining the benefit the plan is supposed to provide!
- Each year, an actuary (basically a mathematician who specializes in managing risk) calculates a range of how much the business needs to contribute to the plan for that year to fund the benefits promised to the participants in #1.
- The cash balance plan provides a guaranteed rate of return called an interest credit. If the plan’s performance doesn’t keep up with the guaranteed rate of return, the business effectively has to contribute more to make up for that. Thus, the risk of poor investment returns (and the benefit of returns that exceed the guarantee) is placed on the business, not the employee.
- Employees do not make contributions to cash balance plans; only the employer does.
- When it’s time for employees to start taking their benefit (usually in retirement), the plan typically has two options. Employees can either take a lump sum — and perhaps roll that lump sum to an IRA if they want to avoid taxes on that lump sum distribution — or they can annuitize it. Annuitize basically means they take a steady income stream for life.
Favorable contribution limits
There are a few key benefits to a cash balance plan. First, contributions to the plan are tax-deductible, just like contributions to other qualified retirement plans like a 401(k). Second, because of how the contribution formulas work, it often allows for very high contribution amounts to older employees (over 40, let’s say), especially those who are highly compensated. For example, a business owner born in 1977 might be able to contribute north of $166,000 to the plan for themselves in 2024. For someone born in 1962, that number is $351,000. Those numbers are based on some major assumptions about the formula used, which may be different than a cash balance formula you use for your specific plan. But hopefully that gives you some perspective. Third, the contribution limits are on top of other qualified plan limits. In other words, you can max out contributions to a qualified plan like a Solo 401(k) and also contribute to a cash balance plan.
In the example above for the person born in 1977, assuming the business generates enough profit, the business owner could contribute $235,000 pre-tax to retirement accounts: $166,000 to the cash balance plan and $69,000 to the Solo 401(k). There are a lot of assumptions in those numbers, but the point is the tax benefits and contributions limits of combining a cash balance plan with another qualified plan can be enormous.
Potential for big tax benefits
The tax benefits of the contributions themselves are a major benefit to cash balance plans. For the business owner with excess cash flow looking for more tax savings, the tax benefits might accomplish that objective. For some business owners, there might be double-whammy tax savings. That might happen because of something called the qualified business income (QBI) tax deduction. The QBI tax deduction, introduced for the 2018 tax year, is a 20% deduction for many owners of a partnership, S or C corporation, LLC, or sole proprietorship. However, if you’re a business owner of a “specified service trade or business” (some health professions, law, accounting, financial services, consultants, and others), you might not qualify for the full deduction if your business makes too much money. But here’s the important part — contributions to a cash balance plan will reduce your business income. The contributions could potentially lower income enough so that you do qualify for the QBI tax deduction. Not only are you saving tax on the contribution itself, but you’re also potentially qualifying for an otherwise-disallowed 20% deduction. You might save 35% (as an example) on the contribution plus another 20% from the QBI deduction.
In addition to tax savings, the other major benefit of cash balance plans is the high contribution limits discussed above. The combination of high contribution limits and tax savings is powerful.
The downside of a Cash Balance Plan
Cash balance plans certainly have drawbacks that need to be weighed against the benefits. First and foremost, they are administratively complex. You need the assistance of professionals who specialize in cash balance plan design and administration. And you’ll need to be comfortable with outsourcing the details to someone else. If you want to understand everything going on with the plan, you’ll need patience as you learn how it works. Because of the complexity and the need for an actuary and other professionals, cash balance plans tend to be expensive. You’ll probably need to spend thousands each year in fees alone, although specific costs vary depending on service providers.
Lastly, you might notice that the amounts we mentioned that you could contribute to a cash balance plan are pretty large. In order to get the tax savings that comes with large contributions, you need to have the discretionary cash flow and be willing to keep it in a retirement account for a certain period of time.
IS A CASH BALANCE PLAN RIGHT FOR YOU?
Cash balance plans are typically a home run for business owners who:
- Already max out other qualified retirement plans like a Solo 401(k)
- Have high cash flow
- Are in a high tax bracket
- Are 40 or older
- Have no employees or just a few young employees
If the business owner is in a specified service trade or business mentioned above, it’s even better. The tax savings will likely dwarf the costs and more than make up for the complexity. Business owners who aren’t in a specified service trade or business (or have a handful of employees) can still gain substantial tax savings when they meet two conditions. First, there must be enough excess cash flow from the business. Second, the owner is okay with contributing for their employees.
Generally speaking, if a business owner is looking for a plan that doesn’t require much in the way of employee contributions, or if the business doesn’t generate a significant amount of excess income, cash balance plans will be expensive and complex enough to cause you to think hard about starting one. Almost certainly, it will make sense to take full advantages of other types of retirement plans before opening a cash balance plan. The cash balance plan concludes our blog series on retirement plans available to self-employed business owners. We hope it’s been helpful. To check out the other types of retirement plans covered in our series, click on the following hyperlinks: Traditional and Roth IRAs, SEP IRA, SIMPLE IRA, and Solo 401(k). If you’re self-employed and wondering what retirement plan is best for your situation, contact us to learn more.
