Reduced volatility and catch-up options abound for high-earners
“…giant steps are what you take, walking on the moon…”
Remember how you felt when you heard this song by the Police back in the day? Your life was a lot simpler and you could not have imagined that these lyrics would relate to you planning for your retirement but stay with me. On the moon the gravitational force is about 17% of that on Earth1. A jump on Earth would get your feet 1.5 feet off the ground and take about a second. On the moon that same jump would get you 10 feet off the ground and last about 4 seconds! That’s about 600% more altitude and 300% more air time! Think about what the impact would be on your taxes and retirement if you could take “giant steps” by increasing your tax-deductible contributions by 200% to 400%.
Why a Cash Balance plan
You may be familiar with the annual defined contribution retirement plan maximum limits of $56,000 (under 50), and $62,000 (over 50) for 2019. If you’re able to “max-out” your current retirement plan with a Safe Harbor 401(k) or SEP-IRA, congratulations! Most savers are not able to reach this significant milestone. But what if you have the capacity to defer more? What if your retirement projections require that you save more? Many pre-retirees may be behind on their retirement savings due to graduate school or medical debt payments, paying for kids’ college, or building a practice or a business. With maximum tax rates of 37% federal and 13.3% state (in California), a Cash Balance Plan2 might be the best approach to help you catch up by maximizing your pre-tax contributions to get you back on track.
Cash Balance Plan maximum tax-deductible contributions for 2019:
|Age||Safe Harbor 401(k) + Profit Sharing||Cash Balance||Total||% Increase|
A Cash Balance Plan complements your existing Safe Harbor 401(k) Profit Sharing Plan because of the advantageous nature of the combined plan testing. With the plans coordinated and tested together, non-highly compensated employees (NHCEs) can get the majority benefit from the Safe Harbor 401(k) and Profit Sharing Plan, and owners and highly compensated employees (HCEs) can get the majority benefit from the Cash Balance Plan. The result is a combination that helps to reverse the adverse impact of progressive taxation and limitations on tax-deductible retirement savings.
Didn’t qualify for the 199A Deduction?
The recent Tax Cuts and Jobs Act3 allows a deduction of 20% of a taxpayer’s Qualified Business Income (QBI). In 2019, the deduction is phased-out if income exceeds the threshold of $321,450 for married filing jointly and $160,700 for a single filer. If you were unable to take this deduction in the previous year because you exceeded the income limits, the income deduction for the cash balance plan contribution may be enough to get you below the threshold. The added benefit is that, unlike the retirement plan deduction that is taxed in the future when distributed, the 20% pass-through deduction is never!
What is a Cash Balance plan?
A Cash Balance plan is a “hybrid” qualified retirement plan that has characteristics of both defined contribution plans and defined benefit plans. Qualified plans such as 401(k), Profit Sharing and Cash Balance all provide significant asset protections under ERISA – The Employer Retirement Income Security Act. These include protections from creditors, bankruptcy and lawsuits. For example, O.J. Simpson had a $33 million judgement against him yet the assets in his defined benefit plan were still protected under ERISA. A “defined contribution” or “DC plan” specifies the limits on contributions, and the future benefit is based on the performance of the investments. DC plans such as a 401(k)s are generally funded with employee deferrals and employer contributions. A “defined benefit” or “DB plan” specifies a future income benefit and the funding is calculated annually to fund that future benefit. Unlike a DC plan, the employer makes all contributions to a DB plan.
A few Cash Balance stats:
- There are approximately 20,452 cash balance plans in place. 14% are in California, and 10% in New York.
- Medical/dental groups and law firms make up 48% of the market.
- The average employer contribution to staff retirement accounts is 6.9% of pay in companies with both Cash Balance and 401(k) plans, versus 4.7% of pay in firms with 401(k) alone.
- 92% of cash balance plans are in place at firms with less than 100 employees and 57% have 10 or fewer employees.
- 96% of Cash Balance plans have an associated Profit-Sharing Plan and 87% have an associated 401(k) plan.
Source: Kravitz 2018 National CASH BALANCE RESEARCH REPORT
The cash balance plan provides a future benefit at retirement in the form of a “plan balance” and the annual funding is based on that target. That future target balance can be as high as $2.8 million. Each participant has a “hypothetical” account balance that grows each year in 2 ways: 1) employer contributions and 2) a guaranteed interest crediting rate (ICR). The employer contribution is a “pay credit” that can be a flat dollar amount or percentage of pay. There are several interest crediting approaches that may be used to achieve the objectives of the plan. A common approach is to set the ICR to a fixed rate of return around 3-5%. Cash balance plan investments are more conservative than 401(k) plans to avoid fluctuations that create large swings in the required funding amounts. Lower volatility, predominately fixed-income portfolios are most common. Unlike most 401(k) plans that provide “daily valuation”, cash balance plan calculations are done annually by an actuary along with the funding requirements the employer must make to the plan. Since older participants have less time until retirement and more pay than younger participants, a given ICR and future target account balance allows older participants to contribute much more than younger participants. This is the magic of compound interest and why cash balance plans are so efficient in helping older HCE’s “catch up”.
Are you a good candidate?
The benefits of a cash balance plan do not come without added complexity, administrative costs and fiduciary liability. However, for many business owners and professionals it is a valuable tool that can help them secure their retirement by making up for lost time, reducing taxes, and building a pool of assets in a conservatively invested, tax-deferred, diversified portfolio.
Cash Balance plans can be good for:
- Profitable practices or businesses of any size that have the capacity to fund a plan for 5 years or more.
- Business owners/professionals that are “maxed out” with their current 401(k) plan design.
- Business owners/professionals that are looking to diversify away from their business and value “asset protection”.
- Closely-held family businesses that are considering intra-family succession.
- Companies looking for a way to improve the way they recruit, reward, retain and retire highly compensated (HCE) employees.
Talk to your advisor to see if adding a cash balance plan is right for you to save more for retirement, reduce taxes, and diversify away from the business. Key professionals that will be involved to help you make the decision are: your independent financial advisor, third-party administrator (TPA), an actuary, and your accountant. With a favorable census that has older owners/HCEs and younger NHCEs, the benefit percentage to the target group can be as high as 85 – 90%+. If the addition of the cash balance plan is a good fit, the projected tax savings will exceed the additional plan costs making it a win for everyone. Cash balance plans may not be appropriate in all situations, but for many it’s the right approach to take “giant steps” to get them back on track.
“…tomorrows another day…I may as well play…”