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Adding Layers – Insulating Clients from Increased Tax Liability and Underfunded Retirement

Adding Layers – Insulating Clients from Increased Tax Liability and Underfunded RetirementWhen used in the same sentence, the words “change” and “tax code” are seldom associated with good news. Yet, every so often, changes in the tax code create opportunities for innovative design that take retirement plans to a completely new level. The Pension Protection Act (PPA) and subsequent regulations have brought new opportunities to effectively combine defined benefit plans and defined contribution plans, building a compelling solution to help insulate clients from the risk of an underfunded retirement and increased tax burdens—the cash balance plan.


Retirement plans fall into two basic categories:

  1. Defined Benefit. Defined benefit plans promise a specified benefit at retirement for each participant, usually in a monthly annuity payable for the life of the participant. This benefit is often based on a participant’s compensation and/or years of service.
  2. Defined Contribution. Defined contribution plans do not offer any They are generally funded with employee salary deferrals and employer contributions, and provide a lump sum payout made up from contributions and earnings.

Enter the Cash Balance Plan—a type of a defined benefit plan that is subject to the same benefit limits as traditional defined benefit plans. What is different is how the plan benefits are expressed. Although the assets are invested in a single pool, in a cash balance plan each participant has a hypothetical account. The account grows annually in two ways:

  1. A contribution made by the employer; and
  2. An interest credit spelled out in the plan, which is guaranteed rather than being dependent on the plan’s investment performance.

For example, a cash balance plan may describe a participant’s retirement benefit as a lump sum amount based on a $1,000 contribution credit (made by the company) and a 5% interest credit earned in the plan. Similar to a defined benefit plan, the plan’s actuary determines the annual funding amount. One of the benefits of a cash balance plan approach is that participants tend to understand them better than a traditional defined benefit approach and recognize their value. For employers, they are easier to understand from the funding requirement perspective than a defined benefit plan.

Prior to the passing of the PPA, for a company offering a cash balance defined benefit plan and a defined contribution plan, the maximum deductible employer contribution to all plans for a fiscal year was the greater of the required defined benefit plan contribution or 25% of participants’ eligible compensation. A paired plan would not increase the employer’s deduction.

However, the PPA changed the rules to allow employers to deduct contributions to a defined contribution plan in addition to the required defined benefit contribution, even if the resulting total exceeds 25% of participants’ eligible compensation (subject to certain limits). Subsequent regulations expanded and clarified how these plans should be designed and operated, further increasing their appeal for closely held businesses.

Who is an Ideal Cash Balance Plan Prospect?

Ideal candidates for a cash balance plan are:

  • Business owners seeking to save substantially more than a defined contribution plan (401(k) or profit-sharing plan would allow on their Given the added cost and complexity of these arrangements, a $70,000 per year contribution goal is when it makes sense to explore this plan option.
  • Businesses that are consistently profitable. Business owners who are planning to work at least three years before retiring, and,
  • Business owners with a substantive difference in the owner’s age and income compared to the non-owner


Building the Layers: Start with a 401(k)

A 401(k) plan allows eligible employees to save a portion of their current compensation for retirement and receive immediate tax benefits, while allowing the money to grow and compound on a tax-deferred basis. A Roth 401(k) alternative trades the current deferral of taxation for tax-free growth and distribution in retirement.

For plans that cover non-owner employees, the employer will typically make a special safe harbor contribution to eligible participants. In doing so, the employer:

  • Guarantees that deferrals of the highly compensated employees do not violate 401(k) nondiscrimination tests (no need to return those contributions to key staff),
  • Helps fulfill the plan’s top heavy requirements (most small business plans are top heavy), and
  • In some cases, can count this contribution as a part of the profit-sharing contribution used to satisfy the non-discrimination

Therefore, a safe harbor contribution really plays triple duty. Missed the safe harbor deadline? No worries, we can still make the plan work with the little-known 5% rule.

Layer #2: Add Profit Sharing

The remaining deduction is typically allocated to participants by way of a profit-sharing plan. Typically, new comparability design is used in this case. This approach allows allocation of the bulk of the profit-sharing dollars to key contributors without violating nondiscrimination requirements outlined by the IRS.


Layer #3: Finish with a Cash Balance Plan

The final layer of a combination plan is the cash balance plan. Contributions to these plans require a complex calculation that encompasses age, compensation, the length of time until retirement, the promised benefit, the assumed growth of plan assets and a variety of actuarial factors. The annual funding requirement is recalculated each year to account for the actual performance of plan assets and any changes to the plan’s liabilities. In general, the more one makes, and the less time they have before retirement, the greater is the contribution required to fund that individual’s benefit under the plan. The result is a robust plan that helps achieve tax reduction and retirement savings objectives. Here is a snapshot of contribution opportunities in a multilayered retirement plan.

Adding Layers – Insulating Clients from Increased Tax Liability and Underfunded Retirement Chart

Setup and Funding Deadlines

Generally, for a plan to be effective in the current year (or for another layer to be added), the plan document needs to be signed or amended by the last day of the employer’s tax year. For most small businesses, their tax year coincides with the calendar year, making December 31 the deadline for current year plan implementation. Employer contributions, however, are not due until the following year. As long as they are deposited before the employer’s tax filing deadline, including extensions, they are deductible for the preceding tax year.


As you discuss year-end tax planning with your clients, consider introducing these concepts to them.

About Cetera® Advisors

Cetera Advisors LLC is an independent broker-dealer and registered investment adviser (RIA) firm offering efficient and convenient access to an extensive network of people, products and services to financial professionals. As part of Cetera Financial Group®, a leading network of independent retail broker-dealers, the firm is able to offer all the benefits of a large, well-capitalized broker-dealer, including innovative technology, leading wealth management and advisory platforms, and comprehensive broker-dealer and RIA services, with the personal relationships often found only at a boutique firm.

Cetera Advisors is a member of the Securities Investor Protection Corporation (SIPC) and a member of the Financial Industry Regulatory Authority, Inc. (FINRA). For more information, visit ceteraadvisors.com.

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