Cash Balance Plans: Potential Big Deductions and Big Retirement Savings

money, pen and note that says Cash Balance Plans

Business owners with high levels of “ordinary income,” particularly in the higher-taxed states, are paying larger proportions of their incomes in tax. The Internal Revenue Service (IRS) is ramping up its audit capabilities and IT infrastructure to increase federal tax collections. States and even cities like New York are working to collect any revenue possible. For these individuals, exploring Cash Balance Plans (CBP) is a strategic move to mitigate tax liabilities while simultaneously enhancing their retirement prospects.

The IRS intensified its focus on taxpayers with substantial W2 incomes, including implementing advanced technologies, such as artificial intelligence, to uncover additional revenue sources. This situation drives successful business owners to adopt forward-thinking tax strategies that comply with regulations and maximize financial advantages.

Among the spectrum of tax-saving strategies, cash balance plans stand out for their effectiveness yet remain relatively untapped. These plans offer the advantage of substantial tax deductions and the potential for significant retirement savings with compounding growth of “gross” contributions over many years. For example, suppose an owner can contribute $500,000 in 2024. That represents a full deduction for the business in the current year. The owner in NYC would probably receive around $250,000 if the money was distributed subject to income tax. Instead, the money now goes into the CBP “gross,” so $500,000 will grow compounded in the stock market for 10, 20, plus years. Year on year, this can be a legitimate wealth-building vehicle.

What Exactly Are Cash Balance Plans?

There are two general types of retirement plans: defined benefit plans and defined contribution plans. A CBP is a defined benefit plan that acts in some ways like a defined contribution plan. Because it incorporates elements of both, it is sometimes called a “hybrid” plan. A defined benefit plan provides a specific benefit at retirement for each eligible employee. A defined contribution plan specifies the amount of contributions to be made in an employee’s retirement account.

CBPs are a hybrid of the two in that they guarantee each participant a specific benefit at retirement, but the benefit is based on ongoing annual contributions. The advantage? The hybrid format of a CBP allows for the larger tax deductions and accelerated retirement savings of a defined benefit plan while maintaining some of the flexibility and portability of a defined contribution plan.

A CBP can help business owners accelerate their retirement savings and realize significant annual tax deductions, primarily because the annual contribution limits for a Cash Balance Plan can be orders of magnitude higher than a 401(k) Profit Sharing Plan. For example, the yearly maximum employer contribution for a 401(k) Profit Sharing Plan is limited to $69,000 ($76,500 for those age 50 and older) for 2024, while the maximum contribution for a Cash Balance Plan can be as high as $409,000.

Ideal Candidates for Cash Balance Plans

Well-established businesses with consistent profitability and a stable workforce are prime candidates for cash balance plans. These plans require a commitment to allocate a considerable sum towards retirement savings on an ongoing basis, so be careful if your revenues are volatile or unpredictable. This could limit the funds available for reinvestment in the business or for annual salaries and draws to owners, so it’s a balance. However, the tax benefits and growth in savings can be very attractive for founders and owners who can afford them. As an owner or executive, can you spare $300,000-500,000 a year pre-tax?

Benefits of Opting for a Cash Balance Plan

Unlike traditional 401(k) plans, where current financial circumstances and legal limits determine contributions (e.g., the maximum amount an employee can contribute in 2024 is $23,000, up from $22,500 in 2023), cash balance plans allow for higher contribution ceilings and more flexible timelines. These plans are particularly beneficial for individuals with multiple income sources, offering a tax-sheltered way to consolidate earnings and later transition them into an Individual Retirement Account (IRA).

The plans allow small to midsize businesses to receive a significant tax cut for employee (and owner) contributions to the plan, and they enable participants to accelerate retirement savings on a tax-advantaged basis beyond what they could put into a 401(k).

Cash Balance Plans also provide autonomy over investment choices, allowing for a broad range of investment opportunities, including traditional and alternative investments, and in some instances, the inclusion of life insurance within the plan on a tax-deductible basis.

The contribution amounts in cash balance plans are determined through complex actuarial calculations, considering factors like age, desired retirement benefits, and retirement age, which can vary annually within a predetermined range.

Challenges and Considerations

The primary challenges of cash balance plans are their complexity and the costs associated with their creation and management. The scarcity of advisors proficient in these plans means businesses must diligently select a knowledgeable financial advisor, CPA, tax attorney, and actuary.

Cash balance plans demand consistent and substantial contributions, making them suitable for individuals with stable, high incomes. These plans might be restrictive for businesses that require flexibility in capital allocation or anticipate rapid employee growth, as they are generally more suited to companies with fewer than 100 employees. It’s crucial for businesses interested in these plans to evaluate their long-term ability to meet the contribution requirements despite potential annual fluctuations.

Cash balance plans, like all qualified retirement plans, must comply with nondiscrimination testing requirements under the Internal Revenue Code to ensure that the plan does not disproportionately benefit highly compensated employees compared to non-highly compensated employees, so if you have the wrong demographic/employee mix, CBPs might not be right for you, but it’s very good for privately held, closely held businesses that have robust cash flows that are reliable with a smaller team.

If you need help or have any questions, please get in touch with Allan RooneySteve WilanskySumangali Rudrakumaror Lauri O’Callaghan, or call us at +1 212 545 8022.

Read more insights from the Rooney Law team here.

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