Every year, millions of business owners, professional services individuals and organizations along with other high income earners across the nation sit with their accountant to find out how much of their personal and company earnings are going to dear Uncle Sam. Like the saying "the only thing that's certain is death and taxes," knowing we have to write a sizeable check to pay our share of taxes can be painful. We invest huge amounts of our time earning a living and caring for employees, to then give away in some cases over 40%. A tough pill to swallow, but what can we do?
Fortunately with the help of your friendly neighborhood CPA, we do have the ability to apply many types of deductions related to our business that can lower the tax liability. The purpose of this article though is not to provide tax advice, but instead give an overview about a retirement planning strategy many owners of medical, legal, accounting and other closely held businesses are possibly unaware of that can help keep more earnings in their pocket.
How Business Owners Can Save More for Retirement
Before I touch on some key points of this popular tax reduction strategy, I wanted to mention a second desire addressed by owners I've worked with: Saving more money towards their retirement. A common theme among doctors, lawyers, accountants and family-run businesses early in the business lifecycle is the inability to save enough money to secure their future. Growing a practice requires recycling profits back into the business. Many years may go by before these professionals can finally start reaping the successes of their hard work.
So what options do many use to minimize taxes and maximize retirement savings? The usual cast of characters might come to mind: traditional IRA, SEP IRA, SIMPLE IRA, solo 401(k) and a company sponsored 401k profit-sharing plan. Each of these qualified retirement accounts come with an annual limit on how much money can be contributed. Let’s review the 2017 contribution limits for each type of plan.
- Traditional IRA - $5,500 ($6,500 if you’re age 50 or older)
- SEP IRA - $54,000
- SIMPLE IRA - $12,500 ($3,000 catch up contribution if you’re age 50 or older)
- Solo 401(k) profit-sharing plan - $18,000 ($24,000 if you’re age 50 or older), with employer profit sharing $54,000 ($60,000 if you’re age 50 or older)
- Company sponsored 401(k) profit sharing plan - $18,000 ($24,000 if you’re age 50 or older), with employer profit sharing $54,000 ($60,000 if you’re age 50 or older)
These amounts might be suitable and within the budget for many trying to accumulate wealth for their future, but for business owners and the professionals I’ve mentioned earlier, these amounts can be a bit underwhelming. With salaries reaching $200,000 and up, the current IRS limits can significantly hinder their ability to attain a comfortable asset base to maintain their current income and lifestyle in retirement. The late start on saving and a high tax rate also present mathematical challenges. (For related reading, see: Top Retirement Strategies: Small Business Owners.)
Cash Balance Plan
Here is a unique option to take a bite out of taxes and keep more of your earnings. An increasingly growing trend in retirement income planning combines two types of IRS-qualified plans: a company’s profit-sharing 401(k) plan with a type of hybrid defined benefit pension plan called a cash balance (CB) plan.
So how does this one-two punch combo work? Marrying a safe harbor 401(k) with a cash balance plan is designed to allow highly compensated owners to potentially contribute three to four times what they could in other traditional defined-contribution (DC) plans on a tax deferred basis. For example, a 60-year-old can possibly see a maximum contribution between the 401(k) profit-sharing plan and cash balance of approximately $300,000 annually versus $60,000 in a 401(k) alone. At the highest tax bracket, that’s a potential tax savings of over $100,000. Now that can have a serious positive impact on your financial future. Cash balance contributions are especially beneficial because they are “above the line” deductions that reduce ordinary income and adjusted gross income. This can move high earning owners into a lower tax bracket and maybe result in a reduction or elimination of the federal tax hikes or phase-out of tax deductions.
How Cash Balance Plans Grow
Cash balance plans grow in two ways. Every year the employer credits a pay credit and an interest credit to each participant’s CB account, regardless of the actual investment performance. All plan assets are pooled in one trust investment account. The business funds the plan, directs the investments, bears the risks and pays the fees. Participants are promised a future benefit which is stated like a 401(k) account balance. Upon retirement or termination, the benefit is fully portable, after vesting, and is usually rolled over as a lump sum into an IRA. (For related reading, see: Cash Balance Pensions: Pros, Cons for Small Biz.)
This duo is not for everyone. Candidates for this type of qualified plan arrangement should have several traits:
- High income, $250,000 or higher, but not always necessary
- Consistent earnings to ensure funding capabilities
- Owners preferably 10+ years older than staff
- 1-5 or 1-10 ratio of highly compensated employees to non-highly compensated employees
- Desire to save more than $50,000 annually and accelerate wealth accumulation
- Commitment to objectives and goals in plan documents
As a disclaimer, these types of plan designs can be complex and have a higher cost and greater responsibility to the employer than other retirement plans. Hiring a highly qualified team with experience in all aspects of these plans is an absolute must for the business owner(s). All plans must be constructed carefully by a TPA or actuarial firm to pass IRS nondiscrimination testing. Providing an up-to-date employee census is needed for an accurate illustration of benefits. Contributions are based on participant age and income as well as other factors, but have design flexibility to fit various business scenarios and goals. The monetary benefits to both the owner and staff still make this an option well worth considering.
(For more from this author, see: The 401(k) Option You Don't Know About.)
Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a Broker/Dealer, Member FINRA/SIPC. Advisory services offered through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Savin Wealth Management and Cambridge are not affiliated.