Reflections

How to Contribute Far More Than $18,500 to Your 401(k)

Adding a cash balance plan to your 401(k) can allow you to make significantly larger retirement plan contributions and save on taxes

A cash balance plan is like a 401(k) on steroids.  Most 401(k) investors understand that wealth creation is based on your ability to save and the return on your investments.   But there is a third factor which is often overlooked: the minimization of taxes.  Fortunately, a lesser-known but extremely valuable solution, known as the cash balance retirement plan, allows profitable business owners to accelerate savings and pay significantly less in taxes.

In the current tax laws, the benefit of a cash balance plan is that it allows far higher contributions than a 401(k), which are limited to $18,500 per year ($24,500 if over 50).  Depending on your age, cash balance plan contribution limits are as high as $250,000 each year.  These contributions bring down your taxable income on a dollar by dollar level.  That means that any income you put into a cash balance plan will not be taxed in that year.

The example below shows how much tax you could save by using a cash balance plan strategy.  After making the maximum 401(k) and profit sharing retirement plan contribution, by adding a cash balance plan you could increase your total annual retirement savings to $315,000.  This equals $116,550 less in taxes paid, assuming a 37% tax rate.

Is a Cash Balance Plan Right for Me?

You can squeeze twenty years of savings into ten with a cash balance plan strategy.  This is extremely valuable for many high-earners who have gotten a late start on retirement.  If you have completed years of schooling or focused your early assets on building your business, a cash balance plan can help you catch up on retirement savings, while paying less tax every year while you do so.

Of course, this is not a “no-strings attached” benefit.  A cash balance plan is a defined benefit plan, much like a company pension.   Unlike a 401(k), which is based on how much money you can put into the plan every year, a cash balance plan is based on how much you can take out of the plan every year once you are retired.  Using your age, expected investment return, and annual compensation, a professional can calculate how much you’ll need to contribute each year to reach your retirement goal.

These defined contribution requirements make a cash balance plan much less flexible than a 401(k).  A cash balance strategy is therefore a good fit only if you can commit to making large contributions year after year.  With that understanding, you might be a good candidate for a cash balance strategy if:

  • You are looking to contribute more than $55,000 a year to your retirement.  A cash balance plan is best used once you have already reached your maximum contribution to a 401(k) and Profit Sharing Plan, and wish to do more.
  • You or your company have consistent cash flow.  Annual contributions to a cash balance plan are required, regardless of profits.  So consistent cashflow is crucial.
  • Your company is willing to make retirement contributions to all other employees.  Cash balance plans are typically established for owners and key executives.  However other employees also benefit.  To meet IRS regulations that all employees are treated fairly, cash balance plans typically provide a minimum contribution of 5%-7.5% of pay to staff in the plan.

Cash Balance Plans and the New Tax Law

As we understand it right now, the new tax law passed in 2017 provides a small reduction in marginal rates, including a drop in the top tax bracket from 39.6% to 37%.  More significant for partners and business owners is a new 20% deduction for “pass-through” businesses (“pass-through” describes a business structure where the income flows through to an individual’s tax return, such as a partnership, LLC, or S Corp).  In practice, this means that many small businesses will now be taxed on only 80% of their “qualified business income (QBI),” providing significant tax savings.

The new 20% deduction looks attractive, but it isn’t distributed equally.  If you are a professional in a “specified service business,” which includes (but is not limited to) industries of health care, law, finance, and accounting, the 20% deduction is phased out and eventually eliminated once certain income levels are met ($157,500-$207,500 single/$315,000-$415,000 married).  Simply put, if you own a specified service business and are a high earner you likely do not qualify for the new 20% “pass-through” deduction.

The good news is that strategic planning with a cash balance plan can cause physicians or lawyers who don’t qualify for the 20% deduction to become re-eligible. Because retirement plan contributions reduce your taxable income, additional plan contributions can help you fall below the $315,000 phase-out limit.  This means that plan contributions not only reduce your tax dollar for dollar, but can trigger an added 20% deduction on your income.  Seen in the example below, a $185,000 contribution creates a $208,000 reduction in taxable income.

Seek Professional Guidance

Because the tax benefits of cash balance plans are significant, designing and maintaining a plan is complex.  It helps to work with a professional, such as Windgate Wealth Management to develop your ideal contribution level and investment target.  Proper planning requires a commitment of time and energy working with a tax advisor, an investment professional, and a plan actuary, along with the associated costs to establish a plan.  However, these costs are typically far out-weighed by the tax savings achieved every year.

Contact us today to learn more about how a cash balance plan might be right for you and your business.

 

Windgate does not provide tax advice. Consult your professional tax advisor for questions concerning your personal tax or financial situation.

Data here is obtained from what are considered reliable sources as of 3/31/18; however, its accuracy, completeness, or reliability cannot be guaranteed. The data above is based on current laws that may change.

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