Tax Savings With the Hybrid Retirement Plan of the Future: Cash Balance Plans

Tax Savings With the Hybrid Retirement Plan of the Future: Cash Balance Plans

Michael R. Kaplan, CPA:
Introduction
As a dentist’s business and income grow, he or she is likely looking for more and more ways to reduce the taxes they pay each year. For a dentist having employees, it used to be that the best tax deduction available was maximizing the 401(k) Profit Sharing Plan (“401(k) plan”). The 401(k) plan can offer tax deductible contributions up to $52,000 for 2014 (or $57,500 if  age 50 or over). What dentist/owners may not be aware of is a relatively new plan called a Cash Balance Plan. When paired with a 401(k) plan, this can significantly increase the total  tax deductible contributions for each owner well beyond the $52,000 allowed in the 401(k) plan. With the proper design, an individual owner’s total contributions may exceed $250,000 between the two plans each year.
 
How Can the Contributions Be So High?
A Cash Balance Plan is a hybrid of a Defined Benefit Plan and is subject to the same contribution limits as that model. The contribution limits consider how much money is needed to fund  an individual’s retirement by the time he or she reaches retirement age, based on actuarial assumptions. Utilizing wages, ages, interest and mortality rates, and other factors, the plan’s  actuary will calculate the contribution maximums based upon the number of years the individual has until he or she reaches retirement age. Generally what this means is that older owners  will have a higher available contribution deduction than younger owners, since the older owner has less time to accumulate the necessary funds by retirement age. For example, an owner  who is 57 could have a contribution up to approximately $203,000 in the Cash Balance Plan, whereas an owner who is 45 could have a contribution up to approximately $112,000. It is  also likely that these limits may increase slightly with inflation. Although the Cash Balance Plan is a form of a Defined Benefit Plan, it looks and feels like a defined contribution plan such  as a 401(k) Profit Sharing Plan, with a beginning balance, contributions, earnings, and an ending balance. Conversely, a Defined Benefit Plan will typically be communicated as a monthly  pension benefit at retirement, which is often difficult to understand in terms of showing the current total benefit within the plan.
 
Can the Owner Also Contribute to a 401(k) Profit Sharing Plan?
The answer here is yes. The owner will be able to maximize his or her 401(k) deferrals ($17,500 if under 50; $23,000 if 50 or over) and also may be able to contribute an additional profit- sharing contribution up to $33,500, which will depend upon the type of company and the number of employees in the plan. From the examples above, the 57-year-old owner may be able  to contribute up to $260,500 in fully tax-deductible contributions between both plans, and the 45-year-old owner may be able to contribute up to $164,000 in fully tax-deductible  contributions between both plans. If the owners are in a 45% tax bracket, this is a tax deferral/ savings of approximately $117,000 and $74,000, respectively. Because these plans are so  advantageous to business owners, tax regulations impose certain tests on both plans that generally require the company to provide a profit-sharing contribution for the employees in the  401(k) plan (which are also fully tax-deductible). The required contribution amount will vary based upon certain testing requirements, but typically the amount will not be less than five  percent of  the employees’ wages. Keep in mind that the owner may be receiving a contribution up to or near 90-100% of their wages, depending upon plan design and testing.
 
Is it Required to Include Employees in the Cash Balance Plan?
Here again the answer is yes. Tax regulations do require that a certain minimum number of employees must be covered in the plan, and those employees need to receive a certain  minimum benefit in the plan. Generally, the non-owner employees will need to receive a contribution of 1.5% to 4% of their wages in the Cash Balance Plan to pass certain tests. (Again,  the owner’s contribution may be up to or near 90-100% of their wages.) Tax regulations also require all qualified plans to not discriminate in favor of highly compensated employees/owners over non-highlycompensated employees. There are numerous methods of testing to determine if the plan is discriminatory.
 
Can the Company Have a Cash Balance Plan Without the 401(k) Plan?
This time the answer is generally, no. Even though the Cash Balance Plan and 401(k) plan are two completely separate plans, the contributions and designs of the plans are treated as  one for testing purposes. Due to the large disparity in contributions for owners versus employees in the Cash Balance Plan, it is necessary to have a 401(k) plan with employer  contributions being provided for employees in order for both plans to pass testing. Therefore, if the larger contributions are desired for the owner, the company generally must have the  401(k) plan in addition to the Cash Balance Plan. Other Items to Consider Non-owner Employee Contributions. As mentioned earlier, it is necessary to include certain non-owner  employees in both the 401(k) plan and the Cash Balance Plan. Since the employees are being covered in both plans, the average total minimum required contributions for the employees  may be in the range of six to nine percent. The minimum required contribution for the non-owner employees is based upon, among other items, various actuarial assumptions, their ages, and the owner’s contribution as a percentage of their total qualifying wages or income. If there is a wide disparity between the owner’s age and the employees’ ages, with the owner being older, there will generally be a lower minimum required contribution for the employees. With that said, the minimum required contribution will typically not be less than six percent between both plans. 
 
Flexibility of Contributions. There is some flexibility in the Cash Balance Plan contributions. However, it is generally recommended that the formula should not be changed frequently. The  plan may be amended to change the formula to decrease or increase the contributions, although there may be limitations based upon the specific situation. 
 
Investments for the Plans. The investments in the 401(k) plan may be directed by each employee in the plan if desired. The investments in the Cash Balance Plan are invested by the  employer in one pooled account, and employees are not allowed to direct any of the investments. The Cash Balance Plan guarantees that the participating employees will receive a  certain return on their account balance that may change from year to year based upon the plan specifications. The plan may indicate that the 30-year U.S. Treasury rates, which were  just under three percent, will be used, or it may use a fixed rate, such as four percent. If the actual investment returns are more or less than the interest rate required to be used, the  contributions may increase or decrease. If additional contributions are required due to a loss on investments, those contributions generally can be spread over numerous subsequent  years. It is for this reason that less volatile investments are typically recommended within the Cash Balance Plan. 
 
Conclusion
Although Cash Balance Plans may appear to be complex, with the proper design and administration they can be made to be as understandable as a 401(k) plan for both owners and  employees. Therefore, it is important to partner with the right administrative and actuarial firm. Finding an actuarial firm that is able to work well with other 401(k) plan administrators,  tax consultants, and investment advisors is a vital first step in designing, implementing, and maintaining a Cash Balance Plan 
 
 
*Michael R. Kaplan is a CPA and CEO/President of Pension Consultants, Inc., Minneapolis, Minnesota. Email is mikek@pensioncon.com