How Business Owners Are Legally Sheltering $300K+ Per Year From Taxes (Case Study)

Where do you turn when you are maxing out the total 401(k) contribution limit (up to $83,250 depending on your age)? Some business owners e.g. doctors, lawyers, consultants, dentists, engineers etc. have very high W-2 wages that put them in the 37% marginal tax bracket. Such professionals are often looking for a way to defer even more income than their 401(k) allows.

Enter the cash balance plan. Cash balance plans are “hybrid” plans - a sort of mix between a defined contribution plan (e.g. 401(k)) and a defined benefit plan (e.g. a pension). And they have one superpower that high earning professionals love. They can allow you to defer hundreds of thousands of dollars in income. They don’t even require you to give up your 401(k). In fact, they are often best paired with 401(k)’s for the best outcomes.

But they aren’t for everyone. So who benefits the most from a cash balance plan?

Who Benefits the Most From a Cash Balance Plan?

Differences in Ages and Wages

The percentage of business owners contributions relative to contributions for all other employees is referred to as the “plan efficiency”. Provided there is a high enough difference between the ages and/or wages of employees and the business owner, it’s not uncommon to see plan efficiency percentages greater than 95%. This means for every $1 put into the plan, 95 cents are for the business owner.

One thing you want to have if you’re considering a cash balance plan is a difference in ages and/or wages. That means if you have employees, you benefit a lot more if they are younger than you and/or make significantly less than you. There are two reasons for this. First, if you set up a cash balance plan, you are making contributions for all of your employees. Second, the amount you contribute to a cash balance plan is determined in part by your age and your income.

Assuming that most business owners are primarily motivated by reducing their tax burden, then that means the older they are relative to their employees and/or the more they make relative to their employees, the more of their contribution will be directed for their own benefit. That’s not to say employees won’t benefit. All else equal, they will be better off than had the business owner never established a cash balance plan.

High Earning Business Owners

Cash balance plans aren’t free and they are quite a bit more complex than 401(k)’s. This means you’ll be likely working with a "Third Party Administrator” (TPA) alongside your 401(k) provider. The TPA will likely charge anywhere from $4,000-$8,000/yr. to administer the plan. Add to that additional costs such as one time set up fees, advisor fees, additional employee contributions, and you’ll be looking at several thousand dollars in increased costs.

To make a plan worthwhile, you’ll want to be able to defer enough income today such that the tax savings more than offset your increased costs. That typically requires a higher marginal tax rate.

Not only does the plan require tax savings to justify the costs but unless your income is high enough, you’re probably not concerned about maxing out your 401(k) anyway. Unless your are really being constrained by your 401(k), a cash balance plan won’t make sense.

Relatively Predictable Revenue

A cash balance plan will have an annual funding requirement. Unlike 401(k) profit sharing contributions which are not mandatory, cash balance plans have annual funding requirements. This means that business owners need to be relatively certain that they will be able to meet their funding requirements annually. Businesses that have “lumpier” income may want to be more cautious considering a cash balance plan.

Relatively few employees

In the same vein as the above, the more employees you have the higher your funding requirement is going to be. Too many employees will drag down the efficiency of the plan. This isn’t to say business owners should avoid making additional contributions to their employees’ retirement. But it is to say that if the goal is to defer as much income for one’s own benefit as possible in the top marginal tax brackets, more employees will make that more difficult than less employees, all else equal.

Time Horizon

Cash balance plans can’t be set up for just a year or two; they must be intended to provide a retirement benefit for the employees. In practice, this means you should plan on having the plan around at a minimum of 3 years but likely longer. The point here is that you can’t use these plans to manage a massive one year increase in income. The benefit wouldn’t likely make such a move attractive and the IRS/DOL will likely take a dim view of a 1 year cash balance plan as well.

Concrete Example

Here is an anonymized example of a client with whom I am currently working on a cash balance plan. My clients are a husband and wife couple that own and operate a small business with 3 employees in addition to themselves. This small business has generated about $1m - $1.5m in annual net income per year. One spouse earns roughly $350,000 in W-2 wages and the other spouse earns roughly $60,000 in W-2 wages. They are about 40 years old and had a safe harbor 401(k) in place.

While the age disparity between the owners and their employees isn’t very large, the earnings difference between them is very large. Thus they have a disparity in ages and/or wages which we noted above is something to look for when considering a cash balance plan.

The first thing we needed to do was find a suitable TPA. We interviewed about 6 different firms and went with a medium sized regional firm. We wanted a firm that was not so large that we would get lost in the customer service shuffle, but also not so small as to lack capability.

Actuaries at the TPA take your age, income, and an interest crediting rate to determine how much you can contribute each year. It was shown that my clients could defer roughly $225k per year into the cash balance plan on top of another roughly $90k to their 401(k). That’s a total deferral of nearly $314k going into their cash balance plan and 401(k). At a 40% marginal state and federal income tax rate, that reduces their tax burden this year by ~$126k. (~$129k if you count total plan contributions)

This particular plan costs about $8,000 in year 1 to administer and then ~$6,700/yr going forward. The efficiency ratio of the plan is 98% meaning that 98 cents of every $1 contributed to the cash balance and 401(k) plan of the company is directed to their accounts. In other words, the business owners are going to be making ~$322k in contributions in their first year of which $314k is directed to their accounts. The other $8,000 in contributions will be for their employees.

Summing up

Cash balance plans are complex but they can be a massive planning opportunity for the right business owner. Be sure to interview several TPAs to find one you like and consider working with an advisor to bring all the pieces i.e. 401(k) record keeper, plan custodian, and TPA together.