A useful tax planning tool is using a cash balance plan.
A cash balance plan is a twist on the traditional defined-benefit pension. This type of plan is one in which the employer credits a participant’s account with an agreeable amount, either percent of pay or a flat dollar amount. Cash balance plans allow employees to contribute more towards retirement than a 401(k) and build substantial tax-deferred accounts in the process. Cash balance plans can give you significant tax savings every year and can even be combined with other qualified retirement plans to produce a larger contribution amount and greater tax deduction.
Cash Balance Plan Benefits:
Unlike the regular defined-benefit plan, cash balance plans are maintained on an individual account basis and each participant can have a different contribution amount. Changes in the value of a participants’ portfolio do not affect yearly contributions. The company bears all ownership of profits and losses in the portfolio and the final benefits received by the participant upon retirement or termination are not affected by portfolio changes.
How Cash Balance Plans Work:
Contributions made to a cash balance plan are age-dependent. The older the participant, the higher the amount is. The reason for this is that the older you get, the fewer years you have to save towards the $2.6 million lump sum that is allowed by a cash balance plan. In 2020, a person born in 1985 could contribute as much as $75,000* into a cash balance plan, plus $57,000 into a 401(k) for a total contribution of $131,000. This is $112,000 more into retirement planning than the 2020 401(k) only plan limit of $19,500. At the same time, a person born in 1965 could contribute as much as $203,000* into a cash balance plan in 2020. Contribution amounts vary depending on how much each participant earns in compensation and years of service.
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A single contribution of $130,000, which earns 5% a year for 30 years, would be worth about $561,000 at the end of 30 years. If the $130,000 had been taxed in the year contributed, and an “after tax” amount was invested, the earnings would only be about $162,000 at the end of 30 years. If the $130,000 had been contributed into an “after tax” type plan, such as a 401(k), then at the end of 30 years, the earnings would only be about $162,000.
Cash balance plans benefit those who desire to contribute more than $50,000 a year to retirement accounts. Key executives, highly compensated employees, or other employees who are already contributing 3-4% of earnings to retirement stand to benefit greatly from these plans. For those who may be considering these plans, it should be noted that cash balance plans require annual contributions, so it is important to have consistent cash flow and profit. Additionally, since cash balance plans are qualified plans, contributions cannot be discriminatory and all employees must receive a contribution.
Why Choose a Cash Balance Plan?
Cash balance allow individuals who earn significant income to secure retirement portfolios quickly. At retirement, participants can take an annuity based on their account balance, or a lump sum. These can be rolled into an IRA or another employer’s plan.
*This maximum contribution estimate is based on certain assumptions that may vary based on your Cash Balance Plan’s specifications.
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