Business owners might have a 401(k) and think they are doing the best they can to save on taxes today and save for retirement tomorrow. What they don’t know is that they can, depending on age, more than triple the amount of tax deferred savings and reduce their taxes at the same time. How to do this? Enter the combined 401(k) / Cash Balance plan.
A 401(k) is a “defined contribution” plan meaning the contributions are defined but the benefits are not. They also have relatively low contribution limits. A Cash Balance plan is a type of pension plan. Just like all pension plans, they have a defined benefit via either a lump sum or guaranteed income stream like most public sector employees receive. Let’s look at a scenario illustrated for an actual client.
Current scenario and assumptions:
- Single owner S-Corp, 45 yrs. old with a 401(k) only
- $500,000 total compensation as follows:
- $120,000 salary
- $380,000 S-Corps distribution
- Assumed effective federal income tax rate married filing jointly: 27.77%
- 401(k) contribution: $18,000 employee deferral, $30,000 employer contribution: Total: $48,000
- Goal Maximize tax savings, maximize pre-tax retirement deferral
SOLUTION: Combined 401(k) Cash Balance Plan
In order to maximize the contribution, he must increase payroll to $265,000 which decreases the S-Corp distribution to $235,000 for the $500,000 total compensation. Wait. You have to increase your salary thus increasing payroll taxes? Don’t want to do that? Remember there is a $118,500 wage limit on social security taxes for 2015 so there is no increase there. There is an increase in Medicare tax but you’ll see it doesn’t come close to impeding the tax savings because of the high deferral/plan contribution amount of $175,000 that he gains with the combined plan.
So let’s see how the numbers play out:
In this case, although payroll taxes increase for a portion of the Medicare tax, the benefit of contributing $175,000 pre-tax to his retirement for the year and by adjusting his salary and corporate distribution amounts, he is able to reduce his combined federal income and payroll taxes by a net of $41,494 for the year and increase his retirement savings by $127,000 for the year.
*These are estimates above only and are not for tax planning purposes. Consult with your CPA for tax issues.
As you can see, the benefits for current-year tax savings are compelling. Furthermore, increasing retirement savings in a tax-deferred account with a defined pension benefit is a big step toward financial freedom. This case study looked at a single owner but these plans work very well with multiple owners like medical groups and law firms, even those with large age disparities across owners.
It’s important to note that these plans take specialized knowledge and a higher actuarial expertise and need to be established with the highest level of competency in order to ensure ERISA and DOL compliance. WorthPointe brings these skills to businesses for plan analysis, establishment, and ongoing management as a fiduciary advisor.
WANT TO LEARN MORE?
Other articles filed under Austin CFP Team Posts
February 13, 2018 - As a financial planner, I’ve certainly been getting my share of questions about the recently passed tax reform. In this article, I’ll address some of the most common concerns I’m hearing from clients, but how the changes in the tax...
February 6, 2018 - By now, you have probably seen the news that the stock market is taking a dip. There is a lot of information coming at us fast as we watch to see what happens next. We are here to answer a...
January 17, 2018 - The beginning of a new year is always a wonderful time to reflect on life in an attempt to change things for the better. With that in mind, I’ve decided to gather some pearls from my favorite sources: my clients...
January 1, 2018 - [embed]https://www.youtube.com/watch?v=B47JLU91HTU[/embed] Health and wellbeing takes attention to all areas of your daily life. You can’t lace up your running shoes once a week or catch a couple of waves and expect vibrant health in return. Eating right, regular physical activity,...
December 18, 2017 - This is an excerpt from the WorthPointe e-book A Financial Planning Guide for the LGBT Community by Kermit Johns. This resource is provided as a complimentary resource to aid for the community. Can We Afford a Child (or Children)? While...
- Five Key Concepts for Financial Success
- Should Bitcoin Be a Part of My Investment Plan?