When it comes to your retirement plan and the retirement plans you provide your employees, maximizing tax efficiency is likely a primary concern. In the right situation, a cash balance plan (a kind of “hybrid” of a 401(k) and traditional pension plan) may be the right answer for you, your business, and your employees.
What Is a Cash Balance Plan?
The two most common types of retirement plans are defined benefit plans, like pension plans, and defined contribution plans, like 401(k)s and 403(b)s.
Defined benefit plans pay a specific benefit amount to each employee, while defined contribution plans pay a benefit based on account contributions and the growth of funds in the account.
A cash balance plan is effectively a hybrid of these two primary account types. Here’s how it works:
- The employer credits a percentage of each employee’s salary to their account each year.
- Each employee earns interest credits each year.
- The employer (not the employee) bears the investment risk.
When the employee retires, they can typically receive their funds as a lifetime annuity or a lump sum.
How Cash Balance Plans Allow Higher Tax-Deductible Contributions
For employees, cash balance plans offer some degree of certainty when it comes to benefits. For employers, these plans offer an opportunity for increased tax efficiency.
That’s because cash balance plans usually have higher contribution limits than 401(k)s and similar accounts. Contribution limits increase with an employee’s age, and they’re also tax-deductible.
How Combined Plan Designs Optimize Tax Savings
On their own, cash balance plans can significantly boost your company’s tax efficiency. However, you can increase your tax efficiency even further by combining a cash balance plan with a 401(k). Here’s how:
- The funds in both the 401(k) and the cash balance plan grow tax-deferred.
- Pre-tax contributions can dramatically lower your company’s taxable income (and your tax bill).
- Thanks to the power of compounding interest, funds in the account can grow substantially.
- In some service businesses, large contributions may qualify for the qualified business income (QBI) deduction.
If your personal retirement plan is a combined plan, you’ll likely enjoy high tax efficiency in your own retirement. Because both plan types are funded with pre-tax dollars, you don’t pay taxes until you take distributions from the account.
Most business owners are in a lower tax bracket when they retire, so this may lead to substantial tax savings.
Why Year-End Planning Is Crucial for Maximizing Deductions
Whether you’re trying to maximize your personal tax efficiency, your business tax efficiency, or both, year-end planning is vital for the following reasons:
- You can verify you’ve met all contribution deadlines.
- You can determine the maximum deductible contribution amount.
- If needed, you can adjust the plan’s design for maximum efficiency.
- You can make accurate tax estimations.
- You can confirm you’ve contributed enough to meet the plan’s interest crediting rate next year.
If you want to make the most of your year-end planning process, get in touch! Our team can help you and your company make the most of your deductions as you wrap up the tax year.
Optimizing Your Tax Efficiency? Let Us Help
At FinancialFocus Retirement Plan Services, we’re committed to helping our clients maximize their tax efficiency, grow their wealth, and build brighter financial futures. Cash balance plans may be unconventional, but for some businesses, they can be transformative.
If you have questions about retirement plans and how we may be able to help, contact us online or email me today at info@ff401k.com.
About Kenny Phan
Kenny Phan is a Managing Partner/Pension Consultant at FinancialFocus Retirement Plan Services. He works as a pension specialist who partners with financial professionals to design and implement pension plans. His area of expertise is customized defined benefit, defined contribution, and 401(k) plans. Serving financial advisors and businesses around the nation, he is supported by FinancialFocus Retirement Plan Services. Together, they provide comprehensive plan design consultation, administration, document installation, compliance testing, as well as IRS and DOL reporting for qualified retirement plans.