Many benevolent business owners have established 401(k) plans and other profit sharing plans to assist in employee retention and reward their employees for all of their hard work. Often though, there are additional motives, such as maximizing retirement saving for the owners themselves and reducing the business’s income tax liability. However, they often find that the employee contribution limit for defined contribution plans ($19,500 for 2020) and the total contribution limit, including employee and employer contributions ($57,000 for 2020) cause business owners to fall short of their goals. While additional catch up contributions of up to $6,000 are available for those 50 and older, this may still not be enough.
A Different Kind of Pension Plan
Traditional “Defined Benefit” pensions, once the mainstay of corporate retirement plans, have fallen out of favor during the past thirty years. One reason is the mandatory annual contributions these plans require of businesses, and another is the risk to plan members that their employer may go bankrupt, leaving plan members with a significantly reduced benefit. But don’t give up on pension plans just yet; other types of pension arrangements exist which can benefit business owners.
A less familiar type of pension, the cash balance plan, can be used alone, or in conjunction with a 401(k) plans to provide additional benefits to employers. Cash balance plans are technically a type of defined benefit pension plan, but differ from traditional defined benefit plans. While traditional pensions promise a future benefit based upon the employee’s years of service and average earnings, a cash balance plan benefit is based upon a “contribution credit” based upon the employer’s contribution plus an “interest credit” specified in the plan document. The employer contribution credit is typically based on a percentage of the plan member’s income, much like a 401(k) contribution. Annually, plan participants receive a statement showing the employer’s contribution credit and interest credit earned on their account. But, there is a caveat – the accounts are only hypothetical. The statement balance, which is the sum of the accrued contribution credit and interest credit, is an amount that will be due to the employee at their normal retirement age as specified in the plan document- usually age 65. So, the actual annual contributions made by the employer are considerably less than the contribution credit amount shown in the employee statements.
How Does It Work?
Each year an actuary calculates the required employer contribution based upon a number of factors including mortality, disability, salary growth, turnover, and anticipated investment return. The goal is to determine how much must be put aside now to provide the promised benefit (contribution credit plus interest credit) to each employee at their normal retirement age. The required contribution is then placed in a pooled account from which all employee benefits will be paid. The plan sponsor (employer) is responsible for choosing how the funds are invested, and may hire an advisor or consultant to provide assistance; however, the sponsor is ultimately responsible for paying the promised benefit to the employees when they reach retirement age regardless of how the fund has actually performed.
Is It Right for Your Business?
Considering the mandatory contributions and investment risk, why would a business owner consider a cash balance plan? The primary reason is that these plans provide business owners the opportunity to defer significantly more income for themselves while reducing business income tax. The annual IRS contribution limits mentioned earlier do not apply to pension plan contributions. The employer contribution is dictated solely by the amount required to fund the future benefit. So, an employer can sponsor a 401(k) and profit sharing plan which defers the maximum contributions allowed by the IRS, and additionally fund a cash balance plan. These combined plans can benefit the business owner at a significantly higher rate than it benefits the employees.
The annual actuarial testing, record keeping, and plan administration will result in additional costs to the employer, but cash balance plans offer the opportunity for considerably higher pre-tax income deferral than can ever be obtained through a defined contribution plan alone. Talk to your trusted advisor to find out how a well-crafted retirement plan can benefit your business.
Rick Bernard | MBA