Imagine you are already doing all things possible to minimize your taxes:
You are maxing out your pre tax 401k. You do tax loss harvesting. You did tax efficient placement. You are maximizing Roth IRA through Backdoor Roth. But what other strategies can you use to minimize taxes?
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, so check with your employer if one is available to you. If your employer doesn’t offer one, this is mainly a tool available to biz owners.
CBP is basically a hybrid between a 401(k) and pension. The contributions into CBP are tax deductible and grow tax deferred until withdrawal. It’s best suited for people in peak earning years, since you should plan on funding it for a few years.
The main benefits of CBP are massive tax savings. Your contributions can be very large (like $100,000+, and often more depending on age and income). You can also have the flexibility to rollover CBP into 401k/IRAs when you leave the plan.
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 boost your tax deductions vs just 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 higher costs (admin/actuary fees, plus investment fees that can run >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 ~$100k is your example amount. At older ages the max can be much higher.
Investments are typically managed by a third party, with a conservative allocation. The plan might be invested with bonds, which means the average historical returns are often in the 4-5% range.
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 into 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 $100k 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, Social Security, etc
Say you will be in a 22% tax rate once you are retired, with 6% state. This means that your CBP contributions will be able to save you 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, separate from service with the employer, or the plan is terminated.
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, you should understand exactly where that money would come from.
This is exactly why cash balance plans are typically recommended for individuals soon to retire. In other words, the chances for large cash outflows might be lower than a 30 year old.
At the end of the day, a cash balance plan isn’t for everyone. High earners in their peak years should definitely consider it though.
Hope you enjoyed this one!
Chat next week.