By: Jerry Alena
As small businesses become successful and enter the maturity phase of their lifecycle, their owners often contemplate how to transform hard work and equity into wealth. One of the most effective and tax-efficient ways to reallocate what otherwise would be taxable business earnings to a tax-advantaged retirement plan is by establishing a Cash Balance plan.
Monetize The Business At Retirement
Cash Balance plans, particularly for business owners in their 50s and 60s offer significantly higher contribution limits than their more popular counterparts, 401(k) Profit Sharing plans. For businesses characterized by meaningful disparity in age and income between owners and employees, employer contributions may be dramatically over-weighted toward owners and other key employees. In many cases over 90% of the total cash balance plan contribution is credited to business owners. Thus, when paired with a 401(k) Profit Sharing plan, business owners may contribute $200,000 – $300,000 per year until they reach a lifetime maximum of $3.4M (indexed).
As with any qualified retirement plan, Cash Balance plan assets are protected from creditors and thus cannot be assigned nor alienated. Medical, legal, engineering, and other highly paid professionals who regularly assume risk and liability are generally receptive to the inherent creditor protection of a retirement plan as well as other asset protection strategies.
The expanded contribution limits of Cash Balance plans permit savers to accumulate as much as $3M+ for their retirement in addition to 401(k) or other defined contribution plan assets. As such business owners and other highly paid employees are much better equipped to convert their retirement assets into a regular income stream, enabling them to maintain a lifestyle similar or even more comfortable to that of their work years.
Risk Reduction of Other Investments
Since Cash Balance plans are designed to provide guaranteed income at retirement, year-over-year investment performance is tied to a fixed or crediting rate, typically 5%. It is critical that the plan’s actual investment performance track closely to its crediting rate. If the plan’s actual performance lags its crediting rate, the plan can become underfunded, causing higher than expected required contributions in succeeding years. Conversely, if the plan’s investment performance substantially exceeds the crediting rate, the plan funding opportunity in succeeding years may be less than expected which in turn reduces annual tax deductions for the business. Asset allocation of cash balance plan assets generally is weighted toward fixed income or balanced with equities. Since plan asset allocation is relatively conservative, in many cases it is prudent for savers to invest their defined contribution plan assets more aggressively, in equities, which historically have outperformed fixed-income assets when measured over multiple market cycles and long periods.
Attraction and Retention of Employees
Since Cash Balance plan benefit formulas allocate greater contributions to the highest-paid and longest-tenured employees, they lend themselves well to the attraction and retention of employees who have the greatest impact on the success of the business. As such they provide businesses with a means of stabilizing their valued workforce so that long-term success is enhanced.
There are other benefits as well as disadvantages to Cash Balance plans that deserve consideration, but small businesses that consistently perform well under varied economic conditions are ideal candidates. Our expert actuarial and plan design team at The Retirement Plan Company (TRPC) are available to answer questions, lead consultations, prepare funding illustrations, and offer general guidance on Cash Balance plans as well as other plans that can be sponsored alongside them or as stand-alone retirement programs.