Cash balance plans are often misunderstood but can be a win-win for tax savings and retirement planning. On this episode of Your Life Simplified, Valerie Escobar, senior wealth advisor, is joined by Daniel Sharkey, senior wealth advisor. They dive into what they are, how they’re run and who they may be right for.

Transcript

Valerie Escobar: Cash balance plans are something of a well-kept secret. And it’s not really so much that they’re a secret, but they’re kind of misunderstood. They are a really good way to save a ton on taxes and use those dollars instead for your own retirement. So it’s one of those win-wins.

Today we’re going to dive into exactly what they are, how we run them and see if they are appropriate for you. You’re listening to Your Life Simplified. I’m Valerie Escobar, senior wealth advisor at Mariner, and I am joined by Daniel Sharkey, also a senior wealth advisor. Daniel, thanks so much for joining us today.

Daniel Sharkey: Oh, it’s great to be here. Thank you for having me.

Valerie: Absolutely. So, tell us about this mystery. What exactly is a cash balance plan? And maybe one of the ways that could be helpful to understand it is comparing it to a 401(k), just because that seems to be something that a lot of clients are pretty familiar with.

Daniel: Yeah, absolutely. So let’s just set it in layman’s terms of exactly what we’re talking about. So there was a piece of legislation in 1974 called the Employee Retirement Income Security Act, more commonly known by the acronym that you all know it as as ERISA. That’s not particularly important, but what that legislation did was effectively define two different types of retirement plans.

You have defined contribution, which is exactly like you mentioned, 401(k)s, 403(b)s, things in which employees can designate a sum into a retirement account on their behalf. The other type of plan is what people would typically call a pension or a defined benefit plan. So if you have firefighters, policemen, teachers, public service employees, or happen to work for a large corporation, think something like GE, they still have a pension plan in place for their employees.

So on one hand you have a 401(k), which the employee controls directly through their contributions. And a defined benefit plan is exactly what it says, there is a benefit for you as the employee at the end of your term of your employment. Think 50% of your last year’s salary that’ll go on for the rest of your life. That particular legislation defined those two types of plans for employers and employees in 1974.

A cash balance plan is unique because it’s what we call a hybrid plan, meaning that it has characteristics from both of those plan types, and that when paired together offer a really unique opportunity for those who fit the right set of characteristics.

Valerie: Okay, so we can assume that we’re halfway familiar with it because we know with the defined contribution, with the 401(k), I know how much money I’m going to put in. Let’s dive into the other side. So tell me more about this cash balance plan. What are the features?

Daniel: It’s a pretty incredible tool, again, if the characteristics line up. So very much like other tax-deferred accounts like your 401(k), those particular tax benefits translate directly to a cash balance plan. There is deductibility when you make a contribution. All earnings and growth of the account grow tax deferred and stay tax deferred until you actually reach distribution.

Very much like a defined benefit plan, you can utilize higher contribution limits and allow the account to grow significantly, exponentially, based on how much you can potentially put into it. So what the IRS is doing is really allowing you the best of both worlds through this hybrid structure to save for retirement, recognizing that there’s a huge deficit for most of Americans.

Valerie: Okay, so it sounds like if I have enough money that I want to put stuff away for my 401(k), but that’s not enough and I want to put more away, then this could help give me a little bit more of that wiggle room to help myself, I suppose, in the future with retirement savings.

Daniel: Absolutely. And the other benefit, if you think about, again, going back to the examples of let’s say teachers or cops, for example, if they were to move departments, move schools, typically their pensions cannot go with them. They are wed and tied to that particular employer to ensure that their retirement benefits get paid out. With a cash balance plan, while you have those similar elements, meaning that you’re saving to a defined amount at a future date, it’s very portable.

That account can be rolled into another tax-deferred account at a later date. So you get to take it with you. So again, that’s where the two elements of both traditional defined contribution, think 401(k), and defined benefit come together because the optionality that you have as the underlying participant is far greater than if you just had one or the other.

Valerie: Wonderful. And I think that’s something that’s underrated, the ability to bring it with you. So many clients I run into, they say, “I used to work at this university, but I don’t remember anything about it, and I thought I remember a statement.” I mean, losing money from just not remembering where something was or not being able to take it with you is a huge benefit or I guess detriment, and so a benefit for the cash balance plan.

So great. I really enjoy that. Appreciate that point. And so ideal clients, what would you say is … I mean, how do we know if this is a good situation for us? For what kind of client is a cash balance plan appropriate?

Daniel: So it really runs the spectrum. But for anyone who is in the higher income brackets, who is looking to save above and beyond what the IRS contribution limits would dictate inside their 401(k). Typically, you would see people who have solo practices or other small businesses, think lawyers, doctors, consultants, anyone who has Schedule C income, who is making enough to ensure that they can obviously meet their living standards, but the current limits through the tax deductibility of their employer plans are not high enough to really suit what their needs are.

So again, identifying who is in their peak earning years, what age that they are, how much they actually need to put away, those are some of the unique characteristics that define the feasibility of a cash balance plan. And I know we’ll talk a little bit about it later, but there are some risks as well. So it’s really important when you are considering a cash balance plan that you have all the facts right at your disposal to really align how this all makes sense.

Valerie: Okay, great. And so generally, people, when you have a high income, you’re able to save a lot. You’re also paying the most in taxes. So it sounds like this double-sided benefit that you’re able to help yourself in both ways. So let’s dive into a little bit of those. What are those risks if we don’t exactly understand what we’re getting ourselves into?

Daniel: Sure. So what the IRS doesn’t like is that this is not a solution for a one-off event, meaning I have a single year of high income that I’m looking to defer. There’s a lot of upfront cost. There’s a lot of actuarial work that has to go into compute exactly what you need to put in based on IRS tables into the cash balance plan based on the age and income levels that you’re at.

And there’s also an interest crediting rate, ICR, or funding rate, for lack of a better term, that needs to be computed to calculate how much the plan stays funded or unfunded. So again, understanding the core elements and exactly how the plan design comes together is really, really important. When Mariner helps input these for clients and put them in place, we involve several different parties.

There’s a lot of actuarial work that we’re talking about. There are a lot of IRS filing requirements that you need to be mindful of. So there are a lot of landmines that you need to be careful of, and working with someone who really understands how those come together is critically important. And if you really can figure that part out and also take into account the other elements of their financial situation.

One example as a risk would be that, hey, we overfunded this cash balance plan, and we’re a little light on assets in other parts of our balance sheet. That’s the type of thing that you really want to be mindful of when you put these in place.

Valerie: Okay, so it doesn’t sound like a really easy, do-it-yourself type of situation. You want to certainly be working with an advisor. But tell me a little bit more about how does the administration and the setup of a plan work?

Daniel: Sure. No, it’s a great question. So when you identify whether or not this is appropriate, what we do for clients right away is understanding exactly how their income is flowing through their tax return. For example, I have a client who retired as a C-suite executive and is now part of several corporate boards in his retirement years, which occupies a fair amount of time, but is a very different career track.

All of that income flows through Schedule C. So he was a prime candidate of someone who is in his 60s who can defer large amounts of income. He has other assets in which to live off of. And that’s how we begin to think about, Is this the right client? Now, once we identify that the fact pattern makes sense and this type of strategy would be beneficial to that type of client, we really do two major things.

One is to make sure that the CPA is on board with exactly the type of income that they have and whether or not it would be suitable for this type of approach. And then we involve a third-party actuary to compute exactly what the contribution rate and the plan design as per the Department of Labor and the IRS could actually look like. So all of those filing requirements are handled by our partners that we work closely with.

But that first step is really ensuring that we’ve input a plan that makes sense for all the IRS guidelines and ensuring that the details of that plan and the amount of money that can actually be contributed is sustainable. So as I was saying earlier, one of the risks is that you have to do this for a series of years. Typically, we like to see at least three years of funding.

So understanding what your employment prospects look like, understanding is this income likely to continue, for how long is it going to continue, those are all things to be cognizant of. Now, there are always safeguards against if something unexpected happens, right? I mean, we’re not talking about you have to predict every outcome possible. But if you know that your income is not going to be the same in future years, this may not be the best strategy for you.

On the flip side, if you do know that this is going to continue, you are potentially looking at hundreds of thousands of dollars of savings, depending upon your age and income levels, and it’s one of the truly uncovered gems that we have been installing for clients for years now.

Valerie: What kind of reaction do you get when you do tell a client about this?

Daniel: So this is the best part. You get really three reactions. One is you have to convince people that this is actually a strategy that they can utilize.

Valerie: This is not fraud.

Daniel: They’ve never heard of it. They think you’re likely making it up. They don’t know where this has come from. Because in their mind, they’ve really only operated along those two pendulums. They’ve either had a pension or they’ve had a 401(k). There’s not many things in between that most people typically see. The second and third are kind of internally intertwined, and that is the pure adulation and joy that comes along their face when they compute exactly how much tax they’re going to save.

But that quickly turns to almost anger and they say, “Well, why the heck has no one told me about this before? And where do I sign?” It is one of the things that is when executed properly truly makes a significant difference, and it provides what we like to say a tremendous path of optionality for other planning aspects in your life. The ability to determine when you pay these taxes as you get later on to defer meaningfully in still-high earning years, especially as you get closer and closer to retirement.

So it’s really a home run when the stars align and these facts come through. And what I hope everyone listening to this leaves with is that if you find yourself in a situation in which you have a similar fact pattern, you have consulting income, Schedule C income, self-employment income, you run a small business, you are a prime candidate for this, and this is typically not something you’re read about on CNBC or any of the other mainstream news outlets that people utilize for these types of questions.

Valerie: Perfect. Yeah, for some reason, the title, the name of the plan, a cash balance plan, just doesn’t strike you as especially interesting, and I think it just makes people fall asleep for some reason. But I guess any landmines that you run into or doubts, I suppose, that clients have? Any, I don’t know, special advice that maybe we haven’t talked about so far?

Daniel: The biggest thing is ensuring that if you … Let’s assume hypothetically that you’re a high income earner who’s in their 60s, again, people who really can take advantage to really significant degrees of the deferral options. I mean, you’re talking 80, potentially 90% of all income through Schedule C that could potentially be deferred when pairing with profit sharing and a 401(k) plan.

So really significant total allocation. You have to make sure that they understand how their living expenses are ultimately going to be allocated for if this income is being currently utilized. So it’s really important both for the advisors and for the client themselves to really take a look at cash flow, to really understand their balance sheet, to really understand the types of accounts and account structure they have to figure out where this is going to come from.

What we like to do typically is we like to isolate a lot of these contributions many years in advance. So we have either a short-term fixed income or bond portfolio, which then feeds this cash balance plan over time. But being mindful of cash flow in these scenarios is critically important.

If you’re making, let’s say, three or $400,000 a year and you’re deferring 90% of that into a tax-deferred vehicle, like a cash balance plan, you’re going to have to eat and travel and do all the other things that you care about, and that money has to come from somewhere. So where are you going to get those assets? That’s a very key consideration as part of the onboarding process.

The other thing is is to ensure that you have the right people. There are filing deadlines. There are contribution limits. There are all things that have to be done for the IRS and the Department of Labor that are non-negotiable. So the plan design, making sure you have the right partners, making sure that the portfolio is designed the correct way, those are all things that are critically important. And if you try to do this on your own, you’re likely to get tripped up.

Valerie: Wonderful. Daniel, thank you so much. I think this is a really useful tool for exactly the right person, but definitely need to know yourself and working with the advisor, I think, will help to get us there. Thank you so much for joining us today. You’ve been listening to Your Life Simplified. Be sure to ‘Like,’ subscribe wherever you are tuning in, and we will catch you next time.

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