Before I get started, it’s time for my customary beginning-of-the-year nag.
By the time you read this, you will have likely received your first paycheck of 2019. Take a minute to see how much of it you’ve diverted into your 401(k) plan. Are you on track to contribute the $19,000 for the year? (Or $25,000 if you’re 50 or older?)
If not, take a minute today to log in and increase your contribution levels. The longer you wait, the harder it will be to catch up. So, get it done now, before your next paycheck.
It’s OK if you’re worried about the stock market taking another spill. No one says you have to allocate your 401(k) to stocks. A money market or stable value fund is a perfectly fine option for now.
It’s simply to get your cash into the account to take advantage of the tax break and any employer matching. The actual investing can happen later.
All right, I got my annual January nag out of my system.
Now, let’s move on to the good stuff.
While the 401(k) is the backbone of most Americans’ financial plan, if you’re self-employed or a partner in a small business, you have even better options at your disposal. In addition to defined-contribution 401(k) plan, you can also build yourself a good, old-fashioned defined-benefit pension plan.
I know what your thinking. Words like “defined benefit” or “defined contribution” are enough to make your eyes glaze over. They might even be enough for you to consider the virtues of jabbing an icepick into your temples.
It’s boring. I know.
But hear me out, because if you play your cards right, you can potentially shield hundreds of thousands or dollars from the tax man… every year.
Paying Yourself First
Very few companies offer traditional pension plans today. They’re expensive to administer, they can be a legal minefield, and at the end of the day, no one wants the responsibility of caring for retired workers decades after they’ve quit working.
This is why most companies moved to defined-contribution plans like 401(k)s. There’s no real risk. Managing the portfolio is the responsibility of the worker, not the company. And if the nest egg doesn’t grow large enough to support the retiree in their golden years… well, that’s their problem.
Hey, I get it. If I were running a large enterprise, I wouldn’t want the open-ended liability of managing a traditional pension for my workers.
But my own retirement? That’s a different story. I don’t mind dealing with the hassle if I’m the one that gets the benefit.
So, with that as an introduction, let me introduce the cash-balance plan.
A cash-balance plan is a traditional defined-benefit pension plan designed for one-man shops or small businesses with a handful of partners. The formula for contribution limits is complex and depends on your age, income and the current value of your plan, among other things. So, it’s probably easiest to explain with examples.
If you’re 40 years old and make $250,000 per year in self-employment income, you can contribute around $106,000 to a cash-balance plan, saving tens of thousands of dollars in taxes. If you’re 50 years old and making $250,000 per year, the amount you can potentially contribute jumps up to over $180,000. And if you’re 55, the number gets close to $220,000.
Sheltering $220,000 per year from the tax man sounds a lot better than sheltering $19,000 to $25,000.
But here’s where it really gets fun. It doesn’t have to be an either/or decision. You can actually do both!
So, playing with examples again, let’s say you’re 50 years old and earn over $250,000. You can dump the first $25,000 into your 401(k) plan, pay yourself an extra 6% in matching or profit sharing, which would work out to another $15,000, and then top it off with a massive $180,000 contribution to your cash-balance plan.
That’s such a phenomenally good tax break, I can hardly believe it’s legal!
There are a few catches, of course. You need a professional to set up the plan and do the annual actuarial calculations, which will cost you several hundred or even a couple thousand dollars per year. You do not want to get cheap here and try to do it yourself, as making any mistakes can subject you to penalties and a potential tax nightmare.
You also have to invest the cash-balance plan conservatively. Just as is the case with an old-school traditional pension, any portfolio losses have to be made up with higher future contributions. It doesn’t matter if you’re the only participant in the plan and you’re effectively “paying yourself.” You face the same risk that General Motors or Ford do when their pension assets fall short of liabilities.
So, you’d want to make sure your cash-balance plan was invested primarily in bonds, CDs or other low-risk investments.
Once you’ve retired or reached the lifetime maximum contribution of around $2.6 million, you don’t have to worry about dealing with the administration of the cash-balance plan anymore. You can simply roll the balance into an IRA and manage it the same way you would with any other retirement account.
Regardless, if you’re looking to turbocharge your retirement savings, you should definitely look into cash-balance plans. There’s simply nothing else out there that can offer the same tax-deferred growth.
Charles Lewis Sizemore, CFA, is chief investment officer of the investment firm Sizemore Capital Management and the author of the Sizemore Insights blog.
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