Will A Cash Balance Plan 401(k) Combo Secure Your Retirement?

For small business owners, who don’t want to have to work forever and want to save on taxes, maxing out retirement accounts can be a win-win. Combining a Cash Balance Pension Plan with a Profit-Sharing 401(k) can provide the largest tax savings for high-income business owners. Depending on your income, you could save hundreds of thousands of dollars yearly in taxes with a Cash Balance / Profit-Sharing combo.

I am always a bit shocked by how often high-income business owners come to me for tax planning guidance, and their current financial advisor and tax pro haven’t even mentioned the Cash Balance Plan as an option for them. It turns out that many financial advisors don’t have the expertise to properly design and implement an optimized Cash Balance Pension Plan. Others are barred by their Wirehouse or broker-dealer from recommending them to their clients. Similarly, if a CPA doesn’t have a fabulous financial planner to implement the plan, they won’t likely recommend one.

The Most Common Small Business Retirement Plans

You have quite a few options when looking to save for retirement as a business owner. In most cases, you will choose the small business retirement plan that fits with what you are willing to save each year for a secure retirement. Some people start with a Traditional IRA or Roth IRA. However, you can only contribute $6,000 per year to one of these accounts.

For those who can save more, the SEP-IRA is quite common. It is one of the easiest to set up, and you can contribute up to $61,000 to a SEP IRA in 2022. It’s important to note that you can only contribute a maximum of 25% of your income to a SEP IRA. Many business owners find their contributions limited.

The Solo 401(k) has been growing in popularity over the past few years. They are relatively easy to set up and maintain. However, you will have a few more filing requirements and more paperwork to open a Solo 401(k) than an IRA. The larger contributions limits make the extra effort worth it. You can contribute both as an employee and employer to a Solo 401(k).

As an employee, you can contribute $20,500 to a Solo 401(k) in 2022. As an employer, you can give yourself a profit-sharing contribution of up to 25% of your salary. The employee and employer contribution can be up to $61,000 for 2022. If you are 50 or older, you can also make a $6,500 catch-up contribution beyond the employer and employee limits mentioned above (a grand total of $67,500 potential contribution.)

For business owners with even higher incomes, those trying to minimize taxes and put away every single dollar into tax-deferred retirement accounts, you should consider a 401(k) /Cash Balance Plan combination. These combined plans can potentially allow you to defer income taxes on several hundred thousand dollars per year.

Benefits Of The 401(k) Cash Balance Pension Plan Combo

When you establish a Cash Balance Pension Plan, you are essentially setting a pension plan on top of your 401(k) plan. Ideally, you make the maximum contributions each year to the 401(k) and then design the Cash Balance Plan to fit your tax planning needs. Your contribution limits for the Cash Balance Plan will depend on your age and income and how the plan is designed.

You can maximize your tax savings each year with a proper Cash Balance Plan design. For business owners who are a bit behind in funding a secure retirement, a Cash Balance Plan and Profit-Sharing combo can jump-start your progress towards financial freedom.

Are There Downsides to a Cash Balance Plan?

For business owners with employees, it isn’t all upside with a Cash Balance Plan and 401(k). You will likely need to make contributions for your employees to both the pension plan as well as the profit-sharing plan. With proper tax planning, the vast majority of contributions will still be going to the business owners.

Similarly, Cash Balance Pensions and 401(k) plans often have set up costs and may require ongoing record-keeping services. If you have a pension plan, you will likely be required to have an actuary review the plan to keep it compliant. While these services are not cheap, the cost of these types of plans pales in comparison to the potential tax savings. Also, I will point out that any cost to run the plan is tax-deductible.

One of the biggest reasons business owners can’t commit to setting up a pension plan is that you will likely need to commit to minimum funding levels for about five years. The minimum levels are based on your business profits. If business declines, your commitment will be lowered. You can also amend the plan each year (if needed) or freeze it. So, the commitment isn’t as scary as it sounds, especially for businesses with a solid cash flow.

Don’t forget any contribution made to your employees is a valuable benefit to them and a valuable tax break for you. With expert tax planning, much of the funding can go towards the business owners. In most cases, something in the range of 85-90% of contributions will benefit the business owner. These percentages will vary depending on the size of the business, payroll, etc.

Who should consider adopting a Pension / 401(k) Combo Plan?

The higher your income, the greater benefit you will get from a Cash Balance Plan combined with a Profit-Sharing plan. First off, with higher income comes higher income tax brackets. Secondly, the higher your income, the more you will need to save, and hopefully, the more you will be able to save.

If you are looking to save less than $61,000 per year, a typical 401(k) plan may be better (at least at this time). Keep the 401(k) / Pension combo on your radar if you are looking to save more now or in the future; your CPA or financial advisor likely will not recommend it.

Assuming the current higher 37% tax bracket, maxing out this plan could save you more than $100,000 in federal taxes each year. Also, your state tax bill will be reduced if you live in a state with income taxes. For those trying to stay below the QBI 20% tax break pass-through income limits, this can also help in that respect. It’s not what you make but what you keep. With that in mind, don’t make strategic tax planning something you do just once a year. The cost is too dang high.

Using Pension 401(k) Stack to get more of the Pass-Through 20% Tax Break

You may have heard of the 20% QBI (Qualified Business Income) tax break for pass-through entities, which started in 2018. If you are running a pass-through entity, that would be considered a “service,” and the 20% QBI tax deduction will begin to phase out as your income increases. For single filers, this phaseout begins at $170,050 in 2022. The QBI numbers are slightly higher for married couples, with the phaseout starting at $340,100.

Look at it this way, your Cash Balance retirement plan contributions will give you a deduction for contributing. Those contributions may also help lower your income threshold listed above. If so, you will be able to get a larger QBI 20% pass-through tax break. You can either earn less money or, in some cases, write a check to yourself in the form of 401(k) and pension contributions. Which would you prefer?