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Small businesses have an alternative to 401(k) plans. A cash-balance plan has much higher contribution limits and is a powerful tool for those needing to accelerate retirement savings.
Maureen is a successful dentist with a booming practice. She was always investing in the newest technology and employed a dozen staff members, including hygienists, technicians and office staff. But at age 58 she had hardly started to save for retirement. She poured everything she earned into the business.
“Maybe I can sell my practice,” she told her advisor. “That might be a way to pay for retirement.”
Maureen’s advisor agreed that a strategic acquisition – or even a well-financed succession plan to pass on the practice to a junior partner – might create retirement security. But he also suggested an alternative: a cash-balance retirement plan.
Cash-balance plans help business owners catch up and accelerate their retirement savings, offering a combination of larger contribution limits, significant tax advantages, conservatively managed investments and account portability. Maureen was lucky her advisor was familiar with this vehicle. Many financial advisors are unaware of it.
Maureen had a modest 401(k) account, which held $250,000. Even if she contributes the maximum $61,000 (indexed for 2022) through her company sponsored 401(k) profit sharing plan, along with the $6,500 catch-up contribution allowable since she is over age 50, she has little chance of reaching the $3 to $5 million goal her advisor says she’ll need to support her lifestyle after retirement.
A cash-balance plan could allow Maureen to contribute as much as $305,000 per year in 2022, while providing substantial tax benefits to both her and her company.
Cash balance basics
Cash-balance plans under the IRS are deemed qualified and tax favored. They are considered hybrid plans in that they offer contribution amounts funded by the employer as commonly found in traditional defined-benefit plans and provide for individual employee contributions, like a 401(k).
When businesses set up a cash-balance plan, the employer (Maureen) has a pooled account created and then credits each participant with a predetermined percentage of their annual compensation, plus a set annual interest rate that is guaranteed. The participant bears no investment risk. The employer can deduct these payments from its taxable income, providing an immediate tax benefit to the business. These funds are then invested in a conservative, fixed income portfolio that typically seeks to provide a benchmark return similar to a 30-year Treasury.
Actuaries are hired to determine the amount an employer must contribute each year as the promised contribution credit to employees. Since the employer is obligated annually to make this contribution, these plans work best for companies with high and predictable cashflows.
Moreover, for companies with the resources to fund these retirement plan vehicles, the benefits can be substantial: It provides rapid asset accumulation, enhanced tax savings and protection from creditors in the event of lawsuits or bankruptcy.
Outsourcing complexity
Cash-balance plans are more complex than 401(k)s. Therefore, business owners should consult with their tax attorney and actuary to determine how much they need to contribute every year. There are penalties for missing these obligations, which can be severe. Since the ultimate goal of cash-balance plans is to “optimize” and not maximize the investment return, the plan’s assets must be invested in such a way that returns target a benchmark.
That complexity is one reason why most financial advisors have shied away from having these types of retirement plan conversations with their most lucrative business clients. However, it can be solved by choosing a turnkey, all-in-one cash-balance offering that includes third-party administrators, actuaries and investment managers who are all experienced in plan design, implementation and asset management. An integrated solution outsources much of the complexity of cash-balance plans for advisors and their clients.
It’s easy to put off planning for retirement when you’re running a busy and profitable professional services firm – and hard to catch up if you wait too long. Cash-balance plans are an appropriate alternative to help your high-income professional clients reach their retirement goals, while adding large pools of long-term assets to your practice.
Ross K. Brown is vice president of business development at Payden & Rygel, a global asset management firm.
Read more articles by Ross K. Brown
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
