Pensions, or Defined Benefit Retirement Plans, have historically been the domain of large Fortune 100 companies and public sectors employers. Can a privately held small business (50 employees or less) create a defined benefit type plan for it’s owners and employees?
In this episode hosts Will Steih and Josh Null discuss one possible pension-like solution for small business owners to consider: a Cash Balance Plan. If you’re a small business owner with an appetite for additional savings above your 401k contribution limits, tune into this episode to learn:
- How a business owner with a fully funded 401k can layer a Cash Balance Plan on top to provide additional future retirement income.
- How a Cash Balance Plan affects a business owner’s overall tax strategy & tax efficiency.
- How a Defined Benefit Plan can be used to fund retirement income needs above qualified plan contribution limits, particularly with highly compensated owners and employees.
- There has been a resurgence in Defined Benefit Plans in businesses with up to 50 employees
- Defined Benefit Plans tend to appeal to business owners with an appetite for additional savings above their 401k contributions
- A Defined Benefit Plan can be used to fund retirement income needs above qualified plan contribution limits
- A Defined Benefit Plan is generally set up to be more conservative than a typical qualified retirement plan
Jump to important points in our conversation:
What is a Cash Balance Plan?
Will Steih 1:57
Cash balance pension plans are a kind of third or fourth generation pension plan design. Whenever people think of a pension plan they think of a Fortune 100 company where at a retirement party of an employee, they perhaps hand them a gold watch in addition gave them a commitment saying hey listen we are going to pay you for the rest of your life a pension that's going to help you retire and hopefully retire well. So cash balance plans are the modern day version of pension plans 30 0r 40, 50 years ago.
Josh Null 2:48
Right. And also so you know, as someone that has been self-employed since my early 20s, I can tell you one of the decision making processes, that would have definitely been on the detrimental side, if you would back then was, man I'm walking away from like, any future income security. I'm old enough that pensions were still kind of a topic of conversation. And we definitely thought about it. So I want to ask you is, you know, can a self-employed person view this as, hey, I have my 401k I have the value of my business? But is there an opportunity for me to set up something that maybe I saw my mother or father enjoy? Or maybe my grandparents in kind of a pension type environment? Is that where we're going with this?
Will Steih 3:28
Sure, you make mention of 401k. So again, in defining cash balance, let me qualify who does this apply to. For business owners, busy professionals, those who actually own their own company, those who are either that or a partner in a firm, with other owners that have a similar mindset. These are owners that have already established a 401k plan previously. They're making contributions on behalf of themselves and their employees where that applies. This could also apply to a one owner or one employee business, call him a solo. But let's take an example of a professional organization. It could be a law firm accounting, maybe it's a dental practice or a surgery group. We're already making contributions on behalf of some employees. Oftentimes will refer to that safe harbor plan. They've already taken steps to help establish a retirement program for their employees and certainly for themselves as well, because they all are also a participant in those plans. But what's left on the table is they still have an appetite for more savings, they have a desire to say "Listen, if I'm in the neighborhood of a 400 500, or $1,000, or more of taxable income, I'd really like to save more, because you know, quite frankly, what the IRS limits you on roughly $60,000 and a 401k plan. If you're contributing $60,000 a year at the age of 50, trying to replace a half a million dollars of income, it's only going to take you so far, that's barely over 10% of the amount. So a cash balance plan. If you think of it this way, you're going to raise the ceiling on what's permissible under the tax code. And this is why their connection back to the historical pension plan applies because those are the same Tax Code, same rules that we're using. And we're going to go ahead and consult with a client and help advise them as to what the capability is just how high is the ceiling. We'll talk more about that. But ultimately, it's we're trying to help the owner save more for his or her future.
How does a Cash Balance Plan benefit the Business Owner?
Will Steih 6:37
Great question, Josh. And that's where using what the rules are in place, this is black and white in the code for the IRS. And so it's a function of a consultant, our case, we're going to advise the client help navigate through that we're getting engaged and actuary as a part of our team to make sure all the I's are dotted and T's are crossed, but to the point of making sure that the percentage of contribution, so the employer is used to if I put $1 in for, for me, I got to put $1 in for everybody else, the non owners, in the case of cash balance plan, the rules will allow for the owner, because typically, the owner is going to have a greater percentage, a greater dollar compensation than anybody else in the company, we are able to be more efficient, so give you an example. So in a cash balance setting, I was talking to a business owner, he or she and I said, you have the ability of the next dollar, you put in this plan, at least 80 cents of the dollar will come back to the business owner, or perhaps the business owners, spouse or partner that really gets the business owners attention to say, Oh, this isn't the same thing as more profit sharing, this is actually going to help the business owner extend and create more savings for themselves in the future. And again, this is going to be a tax deductible contribution, which really helps out when you think in the long term.
Is there an optimal amount of employees for considering a Cash Balance Plan?
Will Steih 8:22
Sure. terrific question. So I've actually just had a situation right now trying to help another advisor, thinking through it that a company is actually making a 6% of pay contribution on behalf of the employees already at the company. So obviously, over time, however, it's come about. It's a big initiative by the employer to try to help the employee save for retirement. So let's say I've got an employee making $50,000 a year, the employer has already committed 6% contribution, that's roughly $3,000. That's a hefty contribution, when you look at the numbers and the demographics around 401k plans, probably twice what the normal average would even be, that's a great opportunity for that employer, you're already essentially spending 6%, to get into the realm to be able to implement a cash balance plan, it's going to roughly cost you somewhere in the neighborhood of 7%. So when you think about this, seven minus six is for an extra 1% of payroll costs, they can incorporate this cash balance plan, in order to raise the ceiling, again, use that term to raise the ceiling for the employer or employers if it's a case of a multiple owner situation. And that's a pretty good bargain. So first of all, I would say it's more so - are you currently contributing on behalf of your employees? And to what extent are you contributing? And then I'd also said there's going to be a limit. So you asked in this case, but sort of like a head count. I would generally say that if I have a business with less than 50 employees, this can be a viable concept. Once you go beyond 50 employees. That's where we start to ask ourselves a question, hey, for every dollar you got to consider, we'll save 100 or 150 there's quite a few people in that mix that you're gonna have to make a contribution for. That's where it does become cost prohibitive.
Can I use life insurance in a Cash Balance Plan?
Will Steih 12:01
In situations where it makes sense. Again, this is one of those cash balance plans and other design, I've looked at just about everything in the last 20 plus years of being in the industry of I've seen so many things come across my desk and so many different concepts, ideas, strategies, and basically, it's entirely focused on trying to place an insurance policy rather than trying to solve for the challenge that a business owner faces. Our use of a life insurance policy would be limited to those situations where we have a business on first of all, it certainly qualifies as a consideration medical underwriting. The other aspect is financial underwriting is something that's going to be feasible and work for the good of the business owner, he or she and quite frankly, we're using it as a Roth alternative, we're actually looking at from standpoint, if structured, properly incorporating a very specially designed life insurance policy. This is not your grandfather's whole life policy, for sure. But it's a specifically designed policy in order to create tax free distributions upon retirement. So imagine it like a super Roth basically, in some cases, that one one business owner kind of exclaim is understanding and revealing this to them. And so over time, that particular piece can be incorporated. Now, here's the good news. Good news is people are typically used to Hey, I've got this life insurance policy, somebody sold it to me, I think it's what I'm supposed to have, I'm not really sure. But all of a sudden, I'm using after tax dollars to pay those premiums, what gets people's attention is the tax code does allow for there to be a life insurance policy owned by the plan itself owned by the trust, that's the plan is incorporated into. So what that means is let's say I'm putting $1 Premium in, in the plan, that's actually probably net savings, like 60 cents after tax. So basically 40% in today's income tax brackets, 40 cents of the dollars that the federal government is now contributing on behalf of the business owner towards the premiums of a policy.
Are there any “Roth-like” investment opportunities for high income business owners?
Josh Null 13:48
Will one point I'll make on that to wrap that part up is one, you said Roth alternative. So for the folks that we are targeting, or they're listening and considering having a cash balance conversation, you're not going to qualify for a Roth anyway, your incomes going to be, you would have probably passed that stopping point at some point in the past of your career. So this is one way for you to get maybe some Roth-like treatment in some of your investments where you don't have access to anymore.
Roth IRA Income Limits: If you file taxes as a single person, your Modified Adjusted Gross Income (MAGI) must be under $139,000 for the tax year 2020 and under $140,000 for the tax year 2021 to contribute to a Roth IRA, and if you're married and file jointly, your MAGI must be under $206,000 for the tax year 2020 and 208,000 for the tax year.
If you would like to continue the conversation with Josh and Will, make an appointment on our website at https://gulfcoastfa.com/, or feel free to call 251-327-2124 email firstname.lastname@example.org.