This article was published in the New Haven Register on July 31, 2020.
If you own a small business or a professional practice — medical, dental, law, accounting,engineering — you should know about an alternative to 401(k) plans that can turbochargeyour retirement savings and ease your tax burden as well.
Cash balance pension plans offer much higher contribution limits than do 401(k) plans.These plans — which date back to 1985 and were codified by the Pension Protection Act of2006 — contain elements of both a defined contribution plan (401(k) plan) and a definedbenefit plan (traditional pensions). Many employers offer both a cash balance plan and a401(k) plan.
With a cash balance plan, the employer contributes a pay credit per employee (usuallybetween 5 percent and 8 percent of salary) and an additional interest credit at a fixed orvariable rate. The employee does not contribute any funds. The pretax money is pooled intoa trust account and invested as a whole.
Owners and employees are guaranteed a certain amount at retirement, regardless of theactual performance of the underlying investments. If the investment returns fall short ofthe promised final pension total, the employer bears the loss.
The plan managers calculate annual benefits, and ultimately total retirement benefits, foreach owner and employee based on a formula that includes wages, the pay credit rate,account balances and the interest credit rate. So high-earning owners are guaranteedhigher retirement sums than are rank-and-file employees, since, say, 8 percent of theirearnings is higher than 8 percent of an employee’s earnings. Federal regulations are inplace to protect the interests of employees in administering these plans.
Unlike a 401(k) plan, cash balance plans must offer employees the option to take either alump sum or annual annuity payments.Business owners note: A cash balance plan is more costly than a 401(k) plan due to setupfees and annual administration costs that include the requirement that an actuary mustcertify every year that the accounts are adequately funded.
Despite the higher costs, many professionals and business owners have converted to cashbalance plans. One reason is because pay credits are allowed to reach far higher annuallimits than are traditional 401(k) contributions, reaching $200,000 a year and up in pretaxcontributions for those 60 and older. That compares with a 2020 limit of $63,500 on401(k) plan contributions by participants 50 and over.
The ability to contribute more money (in the form of employer-paid pay credits, not directemployee contributions) not only boosts investment returns but also shields more incomefrom taxes because these are pretax earnings. With either type of retirement fund the ideais to pay taxes at a far lower tax rate when you begin to withdraw the funds after you retire.Since you can contribute far more under a cash balance plan, you save more in taxes overthe long run.
If you’re an older business owner or a professional, seek out a financial planner to run thenumbers and help you determine whether a cash balance plan might help you improveyour retirement planning and tax planning picture. Your financial adviser will alsoconsider whether setting up both a cash balance plan and a 401(k) plan would be your bestoption.
Eric Tashlein is a Certified Financial Planner professional and founding Principal ofConnecticut Capital Management Group, LLC, 2 Schooner Lane, Suite 1-12, in Milford.He can be reached at 203-877-1520 or through www.connecticutcapital.com. This is forinformational purposes only and should not be construed as personalized investmentadvice or legal/tax advice. Please consult your advisor/attorney/tax advisor. InvestmentAdvisor Representative, Connecticut Capital Management Group, LLC, a RegisteredInvestment Advisor. Connecticut Capital Management Group, LLC and ConnecticutBenefits Group, LLC are not affiliated.