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IMAGINE YOU ARE already doing all things possible to minimize your taxes:
But what other strategies can you use to minimize taxes? You also might not want to start a business or buy real estate.
Another option that many people aren’t aware of is the cash balance plan (CBP). It’s available to business owners (including solo owners) and some employers offer it to high earning professionals (doctors, lawyers, consultants, etc), so check with your employer if one is available to you.
It’s basically a hybrid between a 401(k) and pension. The contributions you put into CBP are tax deductible and grow tax deferred until withdrawal. It’s best suited for people in peak earning years, since you have to commit to contribute for a few years.
The main benefits of CBP are massive tax savings. Your contributions can be very large (like $100,000+). You can also have the flexibility to rollover CBP into 401k/IRAs.
Another unique benefit is that CBPs can be designed alongside your 401(k), allowing you to contribute to both plans in the same year. This “stacking” can supercharge your tax deductions compared to relying on a 401(k) alone.
Risks
If you are a business owner creating a plan for yourself, it’s not something you can DIY. The calculations are complex and require actuaries and CPAs to do it correctly. There are also some specific rules related to overfunding and underfunding, along with structuring and maintaining. But if you are working for a big employer, you shouldn’t worry about it.
These plans typically come with a high fee (>0.5% AUM), but it can still be worth it depending on the tax savings and your circumstances.
Another consideration is that CBPs typically require minimum funding each year (which is why they’re better suited for consistent high earners). If your income is volatile, this could create stress.
Example
Say you are a high earner physician. You might have an option of cash balance plan available to you.
The limit you can contribute to such plan depends on age/income, but let’s say ~$100,000 is your max.
You generally must commit this $100,000 for at least 3 years, and there is flexibility to adjust afterwards. This also means that if you are strapped for cash (e.g. life circumstances have changed) you could adjust your 401(k) amounts you are contributing to adjust for such events.
Investments are typically managed by a third party, with a conservative allocation. The plan might be invested in ~50% bonds, which means the average historical returns are 4-5%. This means that if you do go through with this plan, you can rebalance your other pre-tax accounts (like 401k) to be invested more aggressively and rebalance bonds into the CBP. The funds invested in CBP generally will be allowed to rollover in a 401k or IRA.
Continuing with our example, say you are a 57 year old high earner. Your plan is to retire in 3 years.
Your current marginal tax rate is 37% federal plus 9.3% for state tax rate. So, for every $100,000 you contribute, you defer $46,300 in taxes.
Since you will be retiring in 3 years, you can comfortably predict your tax rate by taking into consideration your pension, 401k withdrawals, taxable dividends, interest, etc. Say you will be in a 22% marginal tax rate once you are retired, with 6% state. This means that your CBP contributions will be able to save you tens of thousands of dollars of tax throughout the 3 year period.
In addition, if you plan carefully, you may be able to pair CBP contributions with Roth conversion strategies after retirement, letting you shift pre-tax balances into tax-free Roth accounts at a much lower tax rate.
Flexibility
As you can imagine, the CBP is relatively inflexible in a sense of withdrawals. The details depend on your plan, but generally the most common scenarios for withdrawing your funds are when you retire or separate from service with the employer.
This means that if you need cash you will need to get it from other places (e.g brokerage account). This is why planning ahead is crucial with CBP. If you do anticipate a large cash outflow, understand exactly where that money would come from if you do enroll in CBP.
This is exactly why cash balance plans are typically recommended for individuals soon to retire. In other words, chances for large cash outflows might be lower.
At the end of the day, a cash balance plan isn’t for everyone. But for high earners in their peak years, it can be one of the most powerful ways to reduce taxes and boost retirement savings.
Bogdan Sheremeta is a licensed CPA based in Illinois with experience at Deloitte and a Fortune 200 multinational.
As a general matter, I try to take a soft approach when consulting on these. I don’t want to “sell” them. If some salesman pushes one on you and it’s not a good fit, there will be much regret later – and it’s usually not the salesman cleaning up the mess. I try to give as much information as I can. I start with saying how much you can deduct, then I tick off all the potential pitfalls, and if they still want the plan after that, then great. It can be a great tool. You do need partners in your journey who will provide you with proactive consulting. I have to walk a fine line when discussing who is making the contributions. Generally, these are 100% funded by the employer, so I cannot say to someone this is how much YOU can contribute to a cash balance plan or how much you can “save” in the plan. Of course, if someone is a sole owner of the business, then certainly they are the ones contributing for themselves. What about a medical practice with 10 partners? Technically, it is their employer that decides how much should be contributed on their behalf, but we all know partner contributions are coming out of that partner’s compensation pot.
My former employer offered something like this called a Deferred Compensation Plan (DCP). Above a certain eligible pay grade, you could enroll each year and contribute a percentage from salary or bonus. The saved money was deferred from that year’s taxable income and paid out in a set future year. You could later change that distribution date but there were many rules and restrictions.
Contributions were invested as each employee chose, from a 401(k)-like menu of options. Because bonus could vary, I saved 20% from salary while also maxing 401(k) savings. I picked the distribution years to form a bridge, from when I thought I might stop working, to the start of my Social Security benefit. The only risk was that my employer would follow companies like Enron or Worldcom and I’d lose the savings. But that risk was tiny for my employer.
When I was laid off at 60, I was so glad I saved this way, and doubly glad now because I am indeed in a lower tax bracket than before.
Keep the great articles coming, we all need more ideas, and yes ways to best pay taxes when taking RMD’s or selling stocks. Too bad RMD’s are like ordinary income.
Thanks for the article Bogdan.
My pre-retirement experience as a CPA in a local CPA firm was that many clients that initially considered a cash balance plan (CBP) would decide not to proceed with adopting the plan was due either a concern that because of CBP participants being guaranteed the amount in their hypothetical account upon retirement that the business bore the risk (investment uncertainty) of any poor investment performance in the plan or all of the additional and ongoing costs associated with the creation and operation of the CBP exceeded the expected tax saving benefits.
Additionally the decision not to adopt a CBP also seemed to me to be an expectation of the plan adoption decision makers that their personal tax rate in retirement years would not be lower than in the contribution years plus worries about possible future changes in the rules that govern qualified plans.
The AICPA’s Journal of Accountancy had a 1/1/2023 article on CBPs for those who want to read further about CBPs. That article has a section, Which clients benefit most from cash balance plans?, which may help in an initial assessment of if a CBP could be a good fit for their business.
My employer converted their traditional pension plan to a cash balance plan in 2001. I wrote extensively about it in an article a couple years back. I ended up taking the annuity option on the CBP when I retired. The conversion cost me at least $15,000 a year income for life compared to what I would have received under the traditional plan formula. I’m still very thankful for my monthly pension. In fairness to my old employer, I should add that at the time of conversion, I did have the option of staying with the traditional plan. What I did not foresee at the time of my decision was that new government pension regulations would force them to change the CBP formulas to a much less lucrative scheme.
You still should have received not less then your accrued benefit under the traditional plan at that point. You can’t lose an accrued benefit upon freezing or converting a plan. But of course, future accruals would be less.
Dick, you are correct. The portion of my payout accrued before the conversion was calculated under the old formula. Unfortunately, it was only a small percentage of the overall benefit.
As a business owner does my participation in a CBP obligate me to contribute for others in my company? Great article, thank you!
You’ll need to give a certain number of other employees a “meaningful benefit” in the cash balance plan. You’ll also need to satisfy a nondiscrimination test, which means giving some or all of your employees certain minimum benefits either in the cash balance plan or in a 401(k)/cash balance combo.
A cash balance plan looks to workers like a DC plan but in reality it is a defined benefit plan (pension plan) and is funded as a defined benefit plan with all the rule and regulations and funding requirements that go with such a plan.
As you said, it’s definitely not DIY.
I put a CBP in for a SP 500 company back in 1995 and to this day many workers will say they do not have a pension plan. Even though the normal form of benefit is an annuity, virtually everyone takes a lump sum because they can see the balance.