Could a cash balance plan reduce taxes and improve your retirement?

High-income earners learn that, as income grows, the options available to shelter that income grow with you. Many individuals start off participating in defined contribution plans like 401(k) plans and SIMPLE or SEP IRAs with annual contribution limits maxing out at $58,000 (in 2021) a year, depending on the plan design and company demographics.

A defined benefit plan can provide a “next level” for retirement saving. For example, consider a cash balance plan. This type of plan is gaining popularity for a variety of reasons. For individuals at the highest end of the income scale, a cash balance plan can allow for contributions of more than $250,000 – $300,000 in a year, depending on current age, company demographics, and retirement age. Cash balance plans require some effort and cost to set up and maintain, but they can significantly improve your ability to reduce taxable income now and improve the quality of your retirement in the years ahead.

What is a cash balance plan?

A cash balance plan is a defined benefit pension plan that delivers current benefits in terms of a higher annual contribution amount and an interest credit. While a cash balance plan is technically a defined benefit plan, it acts and feels a lot like a defined contribution plan in that the amount an individual is ultimately entitled to receive in retirement is generally based on the accumulated contributions and interest credits. This type of plan offers particular value for income earners who are close to retirement, especially those with few or no employees. They also can help executives at businesses where the employee population demographics are favorable (e.g., more young, low-income earners than older, high-income earners).

Is a cash balance plan right for you?

These plans, and the associated tax advantages, work best in a business driven by a small number of high-income earners who are currently contributing at or near the defined contribution limits and are looking for ways to defer more income into retirement. In some instances, we’ve seen executives who retired only to find that they are generating significant amounts of self-employment income as speakers and board members. Though there is no sharp threshold when income that makes a cash balance plan advantageous, we’ve found that if your tax return includes about $200,000 and above of Schedule C income, the benefits of deferral that a cash balance plan offers begin to outweigh the costs of creating and administering the plan.

These plans, and the associated tax advantages, work best in a business driven by a small number of high-income earners.

Creating a cash balance plan

There’s no denying that the setup and administration of a cash balance plan comes with a higher price tag than its defined contribution counterparts because of the requirements applicable to a defined benefit plan. Drafting a plan document and creating a trust to hold plan assets makes the first-year costs of the plan anywhere from 50–100% higher than the annual maintenance fees that one incurs going forward. Once the plan is up and running, it will be required to file a Form 5500 annually. That will require an annual actuarial valuation and it could be subject to audit (though it’s uncommon).

Consider your options

If your company’s high-income earners are looking for more retirement-saving opportunities, or if you’re self-employed and find yourself consistently maxing out your defined contribution limits, you need to be talking with a professional about all of the tax-deferral options available to you.

To learn more about cash balance plans and other retirement strategies for high income earners, please contact Plante Moran.