By Matthew Tuttle, CFP
Many firms that sponsor 401(k) plans have a problem. The owners want to put away as much money as possible, but doing so would require large contributions for the employees. The employees enjoy the opportunity to defer their salary and receive some sort of match, but plan assets are not guaranteed. One solution that could solve both problems is a 401(k) and cash balance combination plan.
Many planners associate cash balance pension plans with large companies that use them to reduce employee benefit costs. What many people do not realize is that, in the right situation, these plans can benefit small business owners as well.
Traditionally, small business owners who want to install a retirement plan for their business had two options: defined contribution plans - such as 401(k)s, profit sharing, money purchase, SEPs, and SIMPLEs - or defined benefit plans. Defined contribution plans limit the cost of contributions for employees, but also limit the tax-deductible contribution for the business owner - $45,000 in 2007. Defined benefit plans allow a large contribution by the owner, but they can also mandate large contributions for employees. Cash balance, however, offers another option: potentially large tax deductible contributions for the business owner with low contributions for employees.
Cash balance plans are hybrids that combine the best features of defined contribution and defined benefit plans. Like a defined contribution plan, employees have their own accounts. Contributions are based on compensation, and interest is credited each year, based on a formula specified in the plan document. Like defined benefit plans, the retirement benefit would be the benefit that can be provided by the employees account or a minimum benefit as described in the plan document, whichever is greater.
Combining a 401(k) with a Cash Balance Plan
Combining an existing 401(k) plan with a cash balance plan can help business owners get large tax deductible contributions without necessitating large contributions for employees. The combination can also guarantee minimum retirement benefits for employees, regardless of what the market does.
XYZ Company, for example, has four owners, three top executives, seven family members, and 19 rank-and-file employees. The owners each make $220,000 per year, the executives and family members earn between $45,000 per year and $180,000 per year. XYZ has a 401(k) plan, but it would like a way for owners, top executives, and family members to put away more money without too much of a cost for employee contributions. By adding a cash balance plan on top of the 401(k), the results were as follows:
-- Tax-deductible contributions for the owners - $86,000 per year for each owner
-- Total contributions for owners, executives, and family members - $433,770 per year
-- Total contributions for employees - $67,646
-- Total plan contributions - $501,416
-- Percentage of contributions that go to owners, executives, and family members - 86.51 percent
The above example assumes that XYZ Company has a safe harbor 401(k) plan that makes a nonelective 3 percent of salary contribution to all employees. This allows the top executives to make their full employee contribution of $15,500 each ($20,500 if over 50). Then, a cash balance plan is placed on top of the 401(k), which skews benefits toward the older, higher-paid employees.
In effect, the plan will save the owners about $200,000 per year in taxes, but the cost of the employees’ contribution is less than $70,000. Employees, then, could invest their 401(k) plan assets more aggressively, knowing that they also have a cash balance plan that provides a fixed benefit in retirement.
In the right situation, adding a cash balance plan can help employers supercharge their 401(k) plans. n
Matthew Tuttle, CFP, is president of Tuttle Wealth Management LLC, located in Stamford, Conn. He can be reached at matthew@matthewtuttle.com.
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