(This article originally appeared in the Philadelphia Inquirer)
When it comes to saving for retirement, most small-business owners are advised to create a defined-contribution plan for themselves or for their companies, the most common being a 401(k) or a simplified employee pension (SEP) plan.
Under these plans, both employers and employees contribute pre-tax earnings (up to a specified limit), which can then be invested and grow tax free until retirement age.
But there is another, lesser known retirement plan that is growing in popularity. Under these plans, an employer commits to contributing a percentage (it’s usually 5% to 8%) of employees’ salary to their retirement funds, which then builds their balances. When employees retire, they can take the money out as a lump sum or an annuity over future years.
These defined-benefit plans are called cash balance plans and have grown in number at a 17% pace compared with just 2% for 401(k) plans, according to industry researchfrom 2020. Almost half of cash balance plans are at firms with fewer than 100 employees.
“These types of plans are the largest growth area in the retirement plan market and are one of the very few tax deduction opportunities available that is well-established and can significantly benefit business owners.” said Zachary Golen, of Broad Street Financial LLC in Bala Cynwyd.
Bobby Cremins, president of Philadelphia-based advisory firm Metanoia Financial, agrees.
“As a small-business owner, you generally want to start with 401(k) plans that have matching and profit-sharing contributions,” he said. “But if you’re still looking to defer more taxes, a cash balance defined benefit plan is ideal.”
What’s the big benefit? Both plans allow employers to include the total contributions they make for their employees as a tax deduction. But because contribution limits rise significantly with age, a business owner more than 60 years old who has a cash balance defined-benefit plan can deduct up to $200,000 each year for contributions to an individual account. Individual contributions made to a 401(k) plan are limited to $64,500.
That’s a significant difference. But the plans do come with drawbacks. The biggest is that because it’s a defined-benefit plan, employers pay workers a given amount of retirement income. Defined-contribution plans, on the other hand, require employees to play a major role in funding their retirement savings.
“This means 100% of the investment risk is on the employer,” Golen said. “ Managing annual funding requirements can be challenging in volatile market conditions.”
Tim Joseph, a financial advisor at Cordasco Financial Network in Plymouth Meeting, added that employers are on the hook for fixed payments due to retired participants. “The employer is responsible for maintaining a certain value of funds in the plan that is calculated annually,” he said. “If a shortfall arises due to poor investment performance, the employer must fund the plan with cash reserves on hand.”
Other drawbacks include the initial setup and annual administrative and investment costs, including the costs of an actuary to make sure retirement amounts are properly funded for the future.
Joseph said that businesses in which owners are near retirement age can benefit most from cash balance plans because contribution limits climb with age and allow for accelerated savings in later years. Advisors such as Golen and Cremins also agree that the best candidates for these plans tend to be older business owners at professional service companies with key employees who maintain predictable and consistent profitability.
“The ability to keep up with plan funding requirements is important, so steady earnings as well as the ability to access funding each year is most important,” said Golen. “As a result, professional practices, consulting firms, tech firms, and any business with a steady income stream model will work.”
Employers aren’t required to fund their pension liabilities incurred each year, but as we’ve seen with some larger organizations and municipalities, underfunding can create big problems in the future.
A cash balance defined-benefit plan may not be the best choice for every small business. But for some, it’s a very tax-advantageous way to stash money aside for retirement.