Cash balance plans for service businesses: Time for a closer look
The Tax Cuts and Jobs Act passed in December 2017 changed the corporate deduction landscape, adding a 20 percent deduction for qualified business income for pass-through entities. But, there’s a catch; the deduction excludes certain service businesses with income above $415,000 (for joint filers, $207,500 for individuals), and it phases out for income between $315,000 (for joint filers, $157,500 for individuals) and $415,000.
Defined benefit plans — cash balance plans in particular — offer the largest opportunity to many service businesses.
Cash balance plans look and feel a lot like traditional 401(k) plans but with, among other differences, significantly higher contribution limits. These plans have been around for the past 20 years and have been especially gaining popularity in recent years for many reasons. If you’ve considered establishing a cash balance plan in the past but took a pass, and your income is near to or north of the $315,000 threshold, now may be a good time for a second look.
You’ll need to act quickly: by December 31 for the 2018 tax year. While setting up a cash balance plan doesn’t require a lot of work, you’ll want to allow ample time to analyze several factors — starting with the ones we cover here — before moving ahead.
Key considerations for cash balance plans
Coverage requirements and nondiscrimination
As with any qualified retirement plan, the Internal Revenue Code (IRC) requires that a certain percentage of employees be covered for it to be considered a qualified plan. In other words, it’s not a plan you can set up for yourself as the owner, or for a small handful of management team members, unless that handful meets the minimum and nondiscrimination requirements set out in the IRC.
Of course, covering and contributing for a greater number of employees adds cost. As a potential plan sponsor, you need to understand the rules and how they apply to your business to know whether the tax benefit outweighs the expense and whether establishing the plan makes sense.
Since cash benefit plan contributions are actuarially determined, an actuary must be involved in the plan’s set-up, which carries a cost. In addition, as a qualified plan sponsor, you’ll have fiduciary, reporting, and investing responsibilities and other ongoing administrative tasks to oversee. Most businesses engage third parties to manage these activities and, yes, that too, adds expense.
But, don’t lose sight of the big picture; we’ve seen many instances where tax savings dwarf administrative costs.
Since contribution requirements for cash benefit plans are dictated by actuarial calculations, the makeup of your staff will have an influence. (Contributions generally will be higher for employees with fewer years until retirement and lower for staff with more years to spend in the workforce.)
Other qualified retirement plan contributions
Businesses already making a healthy contribution to another qualified plan, such as a 401(k) plan, can add a cash balance plan element with very minimal cost. For example, if you’re contributing 3 percent to an existing retirement plan system, you can count that amount toward the cash balance plan contribution for your employees. Not all contributions can be considered for testing purposes, so you’ll need to analyze how your contributions have been structured to determine whether they can offset cash balance plan contribution requirements.
Lack of flexibility
The number-one question we’re asked by owners of service businesses is, “Can I design a retirement system that’s very flexible?” For example, one partner may want to squirrel away funds for retirement while another may need funds now to pay a child’s college tuition, or partners may want to change their strategies from year to year. The short answer is no — cash balance plans aren’t discretionary.
Many service businesses can benefit from cash balance plans, in particular:
- Professional firms with owners’ income less than $415,000
- Firms with a small number of nonowners
- Firms whose nonowners are far from retirement
- Firms with healthy contributions to an existing defined contribution plan
- Firms with consistent income from year to year
If you want to establish a cash balance plan for tax year 2018, you have until Dec, 31, 2018, to execute the plan. To fund it, you have until the due date, including extensions, of your 2018 tax return. While executing the plan document isn’t that time-consuming, the analysis you’ll want to do to weigh the pros and cons is. Give yourself six to eight weeks to make a carefully considered decision.
As always, if you have any questions feel free to give us a call.