Stacking retirement plans accelerates savings and reduces taxes

August 14, 2018
Greg Wambolt

The Tax Cuts and Jobs Act (TCJA) changed tax deductions, making defined contribution retirement plans, such as 401(k) plans and pensions, more appealing for small businesses, entrepreneurs and certain taxpayers with earnings too high to benefit from the new qualified business income (QBI) deductions.

But defined benefit plans come with qualifiers that can reduce benefits for the unwary. Learn whether these valuable retirement vehicles are right for you and how a custom-designed retirement plan might be the answer to achieving your retirement goals faster.

Defined benefit plans

A defined benefit retirement plan provides employees with guaranteed retirement benefits based on an employee’s years of employment and final salary. As with any guarantee, that means risk. In the private sector, employers fund defined benefit plans and handle investments, assuming all investment risk and promising to pay a certain amount to employees at retirement. Employers are responsible for making sure there are enough funds in the plan for payout, even if the plan investments don’t perform well.

Tax incentives are available to employers and employees participating in defined benefit plans. The employer can generally deduct contributions to the plan and employees generally won’t owe tax on those contributions until they receive plan distributions. These plans, however, are governed by a complex set of rules so employers need to master the small print or engage an advisor for guidance.

Defined benefit plans aren’t right for all small businesses. The plans work best for small businesses with few (and younger) employees and a reliable income stream. That’s because employers using a defined benefit plan must:

  • Fund regular defined benefit plan contributions
  • Generally pay more in contribution limits for older workers because they’ve worked longer, are paid better and are closer to retirement

Small business owners behind on their retirement savings can use defined benefit plans to play catch up. The Internal Revenue Service allows a maximum annual contribution to the plan of about $255,000 for people in their 50s.

Tax treatment incentives

While tax reforms in TCJA  don’t change the tax treatment of defined benefit plans, the Act does create a QBI deduction, which encourages the use of these plans. The QBI deduction lets owners of a partnership, sole proprietor, trust or S corporation deduct from taxable income the lesser of 20 percent of the business’ QBI or 50 percent of W-2 wages the business paid the owner. Income limits and certain industries, however, are precluded from eligibility for the QBI deduction.

Defined contribution plans

Unlike the defined benefit plan, which is funded by the employer, defined contribution plans require the employer and employee to both make contributions on a regular basis to individual employee accounts. Retirement benefits are based on the level of contributions plus earnings in the account at the time of retirement.

Defined contribution plans typically cost less and shift risk from employers to employees. The amount employees receive at retirement depends on investment performance; employers are not obligated to pay employees a specified amount at retirement.

Common contribution plans include 401(k), 403(b), employee stock ownership plans and profit-sharing plans. Roth 401(k) plans provide a lower-cost, more flexible defined contribution option for the self-employed or businesses with few and typically younger employees.

Stacking plans

By stacking plans, you can maximize benefits, often putting away more money on a favorable tax basis. In general, if your company has highly compensated employees, if key employees are close to retirement, or if you’ve missed out on contributions in the past, designing a benefits plan around a cash balance plan alone, or in addition to a defined contribution plan (401(k) or 401(b)) already offered, could be the best solution for you. Adding yet another layer, a profit sharing plan, to a combined cash balance and 401(k) plan can further power up tax relief.

A cash balance plan is a defined benefit retirement plan, with similarities to a defined contribution plan. Participants have individual accounts and are entitled to either a lump-sum distribution, similar to a defined contribution plan, or annuity payments (a monthly income stream like that in a traditional defined benefit plan). Lump sum payments are portable and can be rolled over into an IRA or other employer plan.

Assets in a cash balance plan are held in a pooled account. The plan sponsor makes all contributions and manages plan assets, making investment decisions and meeting promised payments regardless of investment performance. Although paying promised benefits is the plan sponsors responsibility, the benefits in most cash balance plans are protected by the Pension Benefit Guaranty Corporation. In addition, by using deductible contributions from a defined benefit plan, owners can also lower income levels to below the QBI cap, providing additional tax relief.

These plans allow you to increase the amount of money you’re setting aside for retirement each year, particularly when you stack a cash balance plan onto an existing defined contribution plan, such as a 401(k) or 403(b) plan. Unlike defined contribution plans that have set maximum contribution levels, the amount you can contribute to the cash balance plan is based on your age. The closer you are to retirement, the higher your maximum contribution amount.

Contributions to employees can be based on a percentage of pay or a flat dollar amount. All contributions you make for yourself and on behalf of your employees reduce your company’s annual tax liability.

Business owners that benefit most from a cash plan are those:

  • Nearing retirement age
  • Wanting to catch up on retirement contributions
  • Making contributions in excess of IRS limits on defined contribution plans
  • Belonging to a professional group that wants to maximize retirement contributions
  • With preditable cash flows
  • Is a family-run or closely-held businesses

Designing the right plan

The vast range of retirement tools and plans available means businesses can custom-design the best strategy for its owners and employees. While companies with younger employees might opt for a profit-sharing plan to lower age-weighted contributions, a business with highly compensated employees may want a cash balance plan to maximize catch up contributions as principals approach retirement.

With the different varieties and strategies out there, layering retirement plans can be complicated. Let’s sit down and review your unique situation and design the right qualified benefits strategy for your business. Contact us for a free consultation.

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