For individuals who are also business owners income tax rates are at their highest level in years. A key objective of business owners approaching retirement is finding a balance between contributing significant sums to tax advantaged retirement accounts while also enjoying substantial current tax deductions. Depending on your tax situation, the solution might be found in a defined contribution plan, a defined benefit plan or in a plan that combines features of both — a cash balance plan.
Defined Contribution vs. Defined Benefit Plans
These days, some of the most popular tax-advantaged retirement plans are defined contribution plans such as 401(k) and profit sharing plans. While these types of plans have many advantages, one major disadvantage, especially for highly-paid business owners approaching retirement, is their relatively low contribution limits. The combined limit on employer contributions and employee deferrals for 2015 is $53,000 ($59,000 for employees age 50 or older).
Conversely, defined benefit plans like traditional pension plans, which provide a specific benefit at retirement, are not subject to contribution limits. Rather, annual payouts an employee may receive are capped (currently at $210,000 per year). This type of plan allows businesses to make substantial contributions on behalf of older owner-employees. If their business offers a defined benefit plan, owners tend to fund their retirement contributions by accepting lower salaries, which results in significant current tax savings.
For these types of defined benefit plans, contribution amounts depend on a number of factors, including an owner-employee's age and the number of years until retirement. Generally, employees must also be included in the plan if they work enough hours and meet other qualification requirements. Contributions on behalf of younger employees may be substantially less, as they have to wait more time until retirement, and as long as the contributions are designed to generate comparable benefits at retirement, this discrepancy in contribution levels does not violate nondiscrimination requirements.
Cash Balance Plans: A More Balanced Approach
Traditional pension benefits are based on years of services and compensation at the end of employment, which results in most benefits being earned in the last years of employment. This makes estimating benefit payouts, especially for younger employees, incredibly difficult.
However, cash balance plans are seemingly the best of both worlds. In a cash balance plan, a form of defined benefit plan, each participant has a hypothetical account balance which is funded by an allocation of certain pay credits (such as a percentage of compensation or a fixed amount) and certain interest credits (a fixed or variable rate that is typically linked to an index). They are called hypothetical in the sense that the account balance does not represent any specific assets; rather, it represents a specific benefit that has been earned by the employee.
This plan offers several advantages. For one, benefits are earned more uniformly over an employee's career and the ability to check one's account balance (or earned benefit) provides greater certainty over benefit payouts for the employer. Additionally, unlike traditional pension plans, benefits in cash balance plans can be paid out in a lump sum or can be rolled over into an IRA or another employer's plan if the employee decides to leave the company.
Business owners who are behind on their retirement contributions may find that a cash balance plan can be a useful tool for both reducing their current tax liability and accelerating retirement savings. It can be used alone or as a supplement to a 401(k) or profit sharing plan.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
