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Posted on November 10, 2020

How Tax-Savvy Small Business Owners Optimize Deductions While Turbo-Charging Their Retirement Savings

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by Perry Bean, Wealth Advisor

Like many business owners, you may have looked to establishing a 401(k) profit sharing plan as a tax-efficient strategy to utilize deductions, accumulate tax-deferred retirement assets, and grow your business through attracting talent and incentivize employees. You and your employees can defer income taxes on compensation and save for retirement by contributing to the 401(k) while your business receives tax-deductions for employer contributions and plan costs.

Given defined contribution plans, such as 401(k) profit sharing plans, have relatively low contribution limits, some business owners turn to defined benefit plans to maximize deductions while rapidly accumulating their tax-deferred retirement accounts.

While many attribute defined benefit plans to the traditional pension plans of large corporations or governmental agencies, defined benefit plans have become increasingly common among tax-savvy small business owners. But rather than a traditional defined benefit pension plan, many elect a “hybrid” variant known as a cash balance plan.

A cash balance plan is similar to a traditional defined benefit pension plan but rather than participant benefits being stated as an lifetime monthly payment, each participant has an “account balance” where their benefit can be clearly illustrated as a lump sum.

Given cash balance plans are employer funded and owners can be often be allocated more than $250,000 per year, tax savings and accumulation of tax-deferred retirement assets can be significant. The contribution limit is age dependent given the plan defines a benefit to be received upon retirement. As such, a 30-year old employee would receive a substantially lower contribution allocation than a 55-year old owner due to the owner’s benefits only having 10 years to grow before retirement. Additionally, cash balance plans also use compensation to determine benefits so a highly paid owner would receive a greater allocation than a lower paid employee.

Elaborating on our example above, our 55-year old business owner has a plastic surgery practice that she has structured as an LLC taxed as an S-Corp. She has two 30-year old W-2 employees and the practice consistently has revenue of $1 million per year. Our owner pays herself a $250,000 salary while her two employees each have salaries of $50,000. With expenses of roughly $200,000, net income averages $450,000 per year. To mitigate her tax liability, she establishes a cash balance plan in 2020 and the company makes a tax-deductible contribution of $220,000 for the plan year. In addition to our owner receiving up to 95% of the allocation in the cash balance plan due to age and compensation, the tax savings for the year could be more than $80,000.

While the advantages of cash balance plans can be substantial, it is important to note a few key considerations. First, to maximize benefits, a business should have consistent annual revenue of $400,000+. Consistent cash flow is key as the annual employer contributions are required. Second, cash balance plans often must be maintained for a minimum of 4 years so business owners are making a commitment to annual funding of the plan for 4+ years. With these considerations in mind, if you are a small business owner looking for an effective strategy to help mitigate tax liabilities while maximizing your retirement savings, a cash balance plan should be a consideration.

*The hypothetical example provided is for illustrative purposes only and should not be deemed a representation of actual results. Actual results may be more or less than those shown.

 

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