Nearly every business owner I meet (and I’ve met a lot of them) complains about the taxes they owe. What surprises me is how few of these successful business owners are getting even basic tax-planning guidance from their financial advisors, let alone excellent proactive tax-planning advice from the advisor or CPA. If nothing else, a financial advisor should be able to help you set up the right retirement plan for your business. Your CPA has probably been telling you to do this for years.
Your local financial advisor may be unable or unwilling to set up the optimal retirement plan for you based on where they work or the licensing they hold. Other financial advisors don't have the time or energy to learn the ins and outs of retirement plans like a Solo 401(k) or Cash Balance Pension Plan. If something like this could save me $50,000-$200,000+ in taxes each year, I'd want to hear about it from the financial experts I surround myself with, wouldn't you?
Case in point: I recently spoke with a business owner earning over 2 million dollars per year. That is a great problem to have, right? Based in Los Angeles, they were paying over 50% in taxes on their last dollar earned. They had been earning around this income level for at least 5 years (and their only retirement account was an IRA. The $7,500 they could contribute to this IRA in 2023 (they are 50+) was nice but not significant in the grand scheme. A few years ago, their CPA told them to ask their financial advisor about opening a cash balance plan. The so-called advisor told them it wasn't worth the hassle, and the conversation ended there. Five years and over two million dollars in missed tax deductions was the result.
After doing a little more digging, this business owner reached out to me to ask, “How big of a hassle would opening a Cash Balance Plan be?” While retirement plans for your business are more complicated than just opening an IRA, the tax savings can more than offset the hassle. In this case, the business owner will still be able to contribute around $425,000 for his family through a combination of a Profit-Sharing Plan and a Cash Balance Plan. If no other tax planning is done, just this strategic move could shelter over $4,250,000 in income over the next decade, likely saving over 2 million dollars in taxes. I'd like to point out that the already substantial tax savings might be even higher, assuming that contribution limits continue to increase over time or if tax rates increase, as expected when the Tax Cuts and Jobs Act (TCJA) expires after 2025.
Taxes aren’t going away, and they aren’t getting simple. Take steps today to ensure you are on track to reach financial freedom. If nothing else, put some time into your tax planning so you can keep more of your hard-earned money.
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How You Can Set Up A Cash Balance Pension Plan
Luckily, technology and specialized financial guidance have made setting up a Cash Balance Plan easier and more cost-effective. I’ve seen a big uptick in inquiries about these valuable retirement plans over the past few years, mostly from small business owners looking to minimize their yearly taxes.
Should You Start A Cash Balance Plan?
A cash balance pension plan is a qualified retirement plan, which the employer solely funds. A cash balance plan could allow for contributions as significant as $3 million in 2024, depending on your income and how far you are from your desired retirement age. More commonly, business owners make contributions in the range of $150,000 to $550,000 per year. This is usually in addition to a 401(k) Profit-Sharing Plan, which only allows a maximum contribution of $69,000 (employee + employer for 2024). If you were wondering, you get a tax deduction for each dollar you contribute to a Cash Balance Pension plan.
There may still be time to set up a Cash Balance Plan for tax year 2023, depending on when you read this post.
Starting A Cash Balance Plan- How It Works
Regarding taxes, a Cash Balance Plan is similar to a 401(k). You get a tax deduction when you make contributions and pay taxes when you withdraw the funds in the future.
A Cash Balance Pension plan is actually a defined benefit plan. The employer makes contributions over time to help fund a "defined pension benefit." In the plan design, the return on assets in the participants' accounts is guaranteed. In the simplest terms, the employer contributes funds to an account to pay out a future pension benefit—for example, $15,000 per month at age 65.
If your investment choices perform better than the guaranteed benchmark return, your contribution will likely be smaller the following year. Conversely, if the plan's investments do not meet or exceed the guaranteed return, the employer will eventually have to make up the difference. The good news is that the shortfall allows for a larger contribution and more tax savings in the future. Also, the business owner has seven years to make up the shortfall. This also gives the investment time to help make up some or all of the shortfalls.
Your financial advisor may not have told you about the benefits of a Cash Balance plan because these pension plans are much more complicated and time-consuming to set up and manage than a plain old IRA. Most of this time and effort falls on the financial advisor and their team, not you, the business owner.
Your fiduciary financial advisor will first need to collect an employee census that outlines the demographics of your employees (assuming you have them), such as employee wages and salaries. With this demographic information, the pension planner calculates how much can go into the plan for executives and owners and how much the employees will have to go in each year to pass IRS testing. There are strict rules to ensure that the plan's benefits don't discriminate in favor of officers, shareholders, or any employees.
The next step in setting up a Cash Balance Plan is putting together a legal document outlining all the plan's details, including the participants' contributions and the annual interest crediting.
In the past, this Cash Balance Plan setup document needed to be signed no later than the end of the fiscal year for which the company wants to take the deduction. This date has changed, and you have until you file your taxes to set up the plan. Be aware that waiting until the last minute to set up your Cash Balance Plan will limit some strategies to optimize the plan for specific tax-planning needs.
You have substantially more time to fund the plan after the end of the year. Contributions to your Cash Balance Plan must be funded by the due date of your tax return, including extensions. That means you have until September 15, 2024, to fund the Cash Balance Plan to get the tax deduction for 2023, assuming you've filed for a tax extension.
The tax benefits are enormous, with a Cash Balance Plan. However, there are drawbacks; you can expect to spend a good amount of money to have the plan set up and administered yearly. The good news is these costs are also tax-deductible business expenses.
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How To Run Your Cash Balance Pension Plan
There are a few other things to remember when managing a Cash Balance Plan for your business. This is not just a set-it-and-forget-it retirement plan. It will take a little bit of work each year. Luckily, your financial planner and the pension team can do most of this heavy lifting.
Not all employees will need to be in the plan. However, once an employee works 1,000 hours during a plan year, you are required to allow them into the plan. So, plan on a midyear checkup to review any hiring or firing you may have done and how this will affect contributions to the plan. If, for some reason, you end up with a surge in new employees and contributing to all of them is unfeasible, you can potentially freeze the plan, even temporarily.
If you end the year with a highly profitable one, you can increase the planned contributions to the plan. You would have until 2.5 months after the year's end to amend an up-and-running plan.
Taking Money Out Of A Cash Balance Plan
Accumulated pension funds can be paid as a lump sum or annuity income. Pension funds can also be rolled over to an IRA when an employee leaves, or the plan is shut down, assuming the plan allows for lump-sum withdrawal pre-retirement.
Setting up a Cash Balance Plan is a big commitment. However, the tax savings can be worth more than the hassle. Work with your fiduciary financial planner to see if a Cash Balance Plan is right for your small business. If that person cannot help with this analysis, it may be time to find an advisor who can.
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