We’ve talked about how to Stash Your Cash in a Solo 401(k) and the fact that Uncle Sam Loves Side Hustlers. You’ve already taken advantage of every self-employed tax break and maxed out every last penny of retirement account space. What if I told you there was even more ways to boost your retirement savings?
In How to hide $215,000 from the IRS I mentioned using a cash balance plan to slash your tax bill. A cash balance plan is a defined benefit retirement plan – the modern version of a pension. If you want to supercharge your retirement savings and minimize taxes during your peak earning years, a cash balance plan can help you achieve your goals.
Defined Benefit vs Defined Contribution
30 years ago it was common for American workers to retire with a pension. They worked X number of years for an employer and upon retirement they received $Y per year. It was good for the employee because it provided a base income for retirement. It was good for the employer because it promoted employee retention. There was just one problem – there was significant investment risk for the employer. If the market crashed the employer still had to write those pension checks every month.
To mitigate this risk employers switched from defined benefit plans to defined contribution plans (401(k), profit-sharing, etc). With a defined contribution plan the employer contributes a fixed amount annually to your account and the investment risk is completely on the employee. If you lose all your money investing in gold futures the employer doesn’t have to chip in more money to make up for your losses.
Defined contribution – each year $X will be invested in an account. The final balance will vary based on asset allocation and market returns.
Defined benefit – upon retirement you will have a balance of $Y. The amount of money needed to be contributed to achieve this benefit will vary based on market returns.
Bring In the Actuaries
These plans are designed with a final balance in mind. The current IRS limit on defined benefit plans is an annual benefit of $220,000 or a maximum lump sum of $2,800,000 at retirement age.
With a desired target in mind, an actuary will design a plan that will ultimately get you to that benefit through a combination of pay credits and interest credits.
Each year a certain amount of money added to the cash balance account. It could be a fixed percentage of your salary or another amount predetermined by your plan’s actuary.
Each year your account is credited a certain amount of interest. In previous years this interest rate was tied to a fixed number, such at the 30 year treasury bill rate. Changes in IRS regulations in 2010 and 2014 now allow cash balance plans to give actual market returns, as long as capital is preserved (the account can’t lose money). This gives these plans more flexibility and decreases the investment risk for the employer.
If the market crashes and the value of the cash balance plan declines, you may have to contribute more the following years to make up the loss. If the market skyrockets and the cash balance plan grows faster than planned you may not need to contribute as much the following year.
The key benefit of a cash balance plan for a highly compensated employee is the sky-high tax-deductible contribution limits. The older you are, the more you can contribute (because you have fewer years to achieve the final defined benefit). A physician born in 1985 may be able to contribute $59,000 to a cash balance plan this year while a physician born in 1965 can contribute $174,000!
Age Contribution Limit
Upon retirement or termination of the plan an employee has 2 options – convert the balance to a monthly pension or rollover the lump sum into an IRA or 401(k). I plan on rolling mine into my 401(k) where the fees are lower and the funds can be invested more aggressively.
What are the Risks?
Mandatory funding requirements: Unlike profit-sharing contributions which can vary from year to year, once you establish a cash balance plan there is a mandatory annual contribution. These plans should be adopted by established businesses with predictable cash flow.
Investment risk: Regardless of market returns the employer still needs to maintain a certain balance in the account. The accounts can be invested very conservatively to decrease the risk but the trade-off is now you may have a significant portion of your retirement savings invested much more conservatively than you would like.
Higher fees: Hiring an actuary to set up the initial account and run the numbers each year isn’t cheap. It may cost you $1,500-$3,000 to set up the account and an additional $1,500-$3,000 per year to maintain the account. Any time you need to make adjustments to the plan or when you decide to terminate the plan there are even more fees. You can quickly see why a cash balance plan only makes sense if you make high annual contributions.
Beware disqualification: The IRS allows these accounts to be created with the understanding they will continue for years and be used to eventually produce a defined benefit. If the plan is terminated shortly after it is started, the IRS may view that as a tax avoidance scheme and disqualify your contributions. If that happens you would owe income taxes plus penalties on your account balance.
How does this apply to self-employed?
Cash balance plans are not just for large corporations. Self-employed physicians can establish a cash balance plan as well. If you make significant money from your side hustles and you foresee this becoming a steady annual stream of income you can establish a personal cash balance plan as a sole proprietor.
Only you can decide if your income is steady enough and if the benefits outweigh the risks. If you are interested in creating even more tax deferred retirement space a cash balance plan might be right for you.
Want to learn more?
Check out these helpful links to learn more about cash balance plans.
What do you think? Have you ever participated in a cash balance plan through your employer? Have you ever set up a plan as a sole proprietor? Share your thoughts and comments below.