Tax-Effective Retirement Planning: Should You Adopt a Cash Balance Pension Plan?
Kegler Brown Employee Benefits Update January 17, 2013
Saving for retirement is certainly important. Doing so in a tax-effective manner will increase the likelihood of success, and with the passage of the American Tax Relief Act of 2012 and the increase in the effective tax rates for the highest earners, income tax planning has become even more important.
When the employer makes contributions to a qualified retirement plan, the contributions are tax-deductible. Further, the investment buildup inside the plan is not taxed. Accordingly, the use of a qualified retirement plan for an owner of a business to save for retirement is standard procedure. However, a defined contribution plan, such as a profit sharing plan, has its limitations especially when the owner of the business is fast approaching retirement age. In 2013, the maximum amount that can be contributed to a defined contribution profit sharing plan for the benefit of an owner of a business is $51,000. This is an increase of $1,000 from the annual limitation that applied in 2012.
So, how did a group of 5 owners go from this annual allocation to their qualified retirement plan in 2012;
Name |
Age |
Compensation |
Contribution to the accounts of the employees |
Contribution as a Percentage of Compensation |
|
|
|
|
|
Owner A |
64 |
$250,000 |
$50,000 |
20% |
Owner B |
57 |
250,000 |
50,000 |
20% |
Owner C |
57 |
250,000 |
50,000 |
20% |
Owner D |
54 |
250,000 |
50,000 |
20% |
Owner E |
48 |
250,000 |
50,000 |
20% |
Rest of Employees |
|
852,114 |
170,423 |
20% |
|
Total: |
$2,102,114 |
$420,423 |
|
to this allocation?
Name |
Age |
Compensation |
Contribution to the accounts of the employees |
Contribution as a Percentage of Compensation |
|
|
|
|
|
Owner A |
64 |
$250,000 |
$125,500 |
50.2% |
Owner B |
57 |
250,000 |
125,500 |
50.2% |
Owner C |
57 |
250,000 |
125,500 |
50.2% |
Owner D |
54 |
250,000 |
125,500 |
50.2% |
Owner E |
48 |
250,000 |
120,000 |
48% |
Rest of Employees |
|
852,114 |
74,127 |
8.77% |
|
Total: |
2,102,114 |
$696,127 |
|
So, how did a group of 5 owners go from this annual allocation to their qualified retirement plan in 2012;
The answer is that the owners converted their plain vanilla profit sharing plan (whereby employer contributions are allocated to the accounts of the plan participants based on compensation ratios) to a combination of a safe harbor 401(k) plan and a cash balance pension plan.
The workings of a safe harbor 401(k) plan are fairly well understood, and therefore this newsletter will not go into great detail on these workings. In the example given above, the safe harbor 401(k) plan was structured such that the employer contributes on an annual basis an amount equal to 3% of the compensation of each plan participant. In addition, the employer makes a discretionary profit sharing plan contribution that is allocated so that each non-owner receives a contribution equal to 2% of their compensation with each of the owners receiving a contribution equal to in excess of 10% of their compensation. With application of “cross-testing” (whereby discrimination is tested after contributions are converted to benefits payable at retirement) this “discriminatory allocation” passes IRS scrutiny. The employer contributions are in addition to the salary deferrals made by the employees. In the example above, the owners maximized their salary deferrals which included a “catch-up” contribution (with the exception of owner E who was not old enough to make a “catch up” contribution).
So what are the workings of a cash balance pension plan?
A cash balance pension plan, like a 401(k) plan, is a qualified retirement plan governed by strict tax rules which, if followed, will qualify the plan for tax deferral, income tax deductions and creditor protection under ERISA. Also, like a 401(k) plan, the promised benefits are essentially described as an account balance. However, unlike the 401(k) plan, (which is a defined contribution plan) a cash balance pension plan is technically a defined benefit pension plan. Therefore, the contribution levels to the accounts of the plan participants can be much higher. Because a cash balance pension plan is a defined benefit pension plan with benefits described as account balances, like a defined contribution plan, it is sometimes referred to as a “hybrid” plan. Accordingly, a cash balance pension plan has positive features from both categories of qualified retirement plans.
A cash balance pension plan specifies the dollar amount or percentage of compensation per year to be credited to the participant’s account (“hypothetical employer contribution”) along with a hypothetical rate of return (“Interest Crediting Rate”). The interest crediting rate might be a variable indexed rate, such as one geared to 30-year treasury bonds, or it could be a fixed rate. The structure of the plan, subject to discrimination laws, can be very flexible. For example, the plan could have two owner/principals who are the same age and earning the same salary, getting different benefits. Or, you might have two owner/principals of different ages getting the same benefits. In the example given above, all five owners (with a minor difference in the fact that one owner was less than 50 years of age and therefore could not make a salary deferral “catch up” contribution) had the same contributions allocated to their account balances.
Unlike a defined contribution plan, there are no contribution limits per se, for a cash balance pension plan. Rather, there are benefit limits. It is the benefit limits that drive the funding. For example, the benefit limit for 2013 is a life annuity of $205,000 per year, commencing at age 62. This translates to a lump-sum distribution of approximately $2.4 million. Because the benefit is defined as a hypothetical employer contribution increased by the Interest Crediting Rate, the benefit being provided is independent of the plan’s investment performance. However, the objective with any cash balance pension plan is to obtain a rate of return on the actual investments commensurate to the Interest Crediting Rate. The IRS requires that the Interest Crediting Rate be a “market rate of return.” Translated, the Interest Crediting Rate must be a moderate rate of return. A 4%-5% rate of return, for example, is typical.
To maximize retirement planning in many situations, a cash balance pension plan in combination with a safe harbor 401(k)/profit sharing plan works well. The example given to you above was exactly that combination. As you can see, when the retirement plan offered was a plain vanilla profit sharing plan, each and every employee had 20% of pay contributed to the plan on a yearly basis (in the aggregate, $250,000 was allocated to the owners’ accounts representing 59.5% of the total contribution to the plan). However, when the plan arrangement was converted from a profit sharing plan to a safe harbor 401(k)/profit sharing plan in combination with a cash balance pension plan, the owners not only had more allocated to their accounts, but the rank-and file employees had less allocated to their accounts resulting in a much higher percentage of the allocations going to the owners of the company (in the aggregate, $622,000 was allocated to the owners’ accounts representing 89.4% of the total contribution to the plans).
So, who are good candidates to set up a cash balance pension plan? Since a cash balance pension plan calls for more substantial contributions than a defined contribution plan, any company (including a sole proprietor) that wants to increase contributions to the retirement accounts for their owners, partners, or employees should consider cash balance pension plans. Partners or key employees who desire to contribute more than $51,000 per year towards their retirement should consider a cash balance pension plan. Companies who already contribute 3% 5% to the employees in any defined contribution plan context or are at least willing to do so should consider the combination of plans discussed herein. The company should have a consistent cash flow and be profitable. If the partners or owners of a company are over 40 years of age and the average age of the rank-and-file employees is ten years or less than the owners, a cash balance pension plan works well. This is especially the case if the partners and owners desire to “catch-up” or accelerate their pension savings because they are nearing retirement.
Cash balance pension plans are ideal for highly profitable companies of all types and sizes, especially where the principals earn more than $250,000 per year. These plans work well for closely held businesses, whether family-owned or not, law firms, medical groups of all sizes, and professional firms of all types. These plans are extremely important for older individuals who have delayed saving for retirement, for those individuals who highly value asset protection, and for companies who want to enhance benefit packages for their executives.
Not every financial advisor, attorney, benefits administrator or benefits professional understands the intricacies of cash balance pension plans. Therefore, it is imperative that a company that wishes to explore the establishment of a cash balance pension plan seek out the services of a good team of advisors to both establish and administer any such plan. The company should also seek out the services of a money manager that has experience with cash balance pension plans so as to properly invest the assets of the plan. These plans are complex from the perspective of their internal workings. However, the general workings of these plans are not hard to comprehend. Simply put, an annual contribution, plus a defined rate of return, is promised to the plan participants. And if the investment performance of the plan assets is commensurate with the Interest Crediting Rate, then the sponsoring company contributes the promised annual contribution.
To learn more about how a cash balance pension plan can benefit your company, please contact the chair of our Employee Benefits & ERISA area, Tom Sigmund.