The Ultimate Tax and Retirement Strategy for High Earners

Everyone's heard of pension plans, but have you heard of a cash balance plan? It’s a way to sock away large amounts of cash for retirement on a tax-deductible basis.

(Image credit: Ismagilov)

When people think of retirement accounts, they often think first of a 401(k) plan. 401(k)s are certainly great options, but they come with contribution caps that could fall short of some participants’ hopes. This is where a cash balance pension plan comes into the picture, because they have contribution limits that can top $200,000 annually, depending on your salary and age.

However, before we examine the cash balance plan, let's take a closer look at the two main types of pension plans: defined benefit plans and defined contribution plans.

Plan differences

The goal of a defined benefit plan, what most of us would call a pension, is to provide a specific benefit at retirement for eligible employees. This would typically be a monthly payout similar to Social Security. The amount of the benefit isn’t reliant on the employee kicking in: It’s a set amount usually based on the salary of participants during their final, usual top-earning, working years. Upon retirement age of at least age 59½, pension distributions are taxed at the recipient’s ordinary tax rate. Presumably, this rate is substantially lower than the tax rate during the recipient’s high-income employment years.

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On the other hand, defined contribution plans, such as 401(k)s and 403(b)s, specify a contribution that can be made by the employee and employer. In a defined contribution plan, the amount of benefits employees get upon retirement depends on the cumulative amount of contributions made to the plan, along with investment gains or losses. For 2017, the combined 401(k) employee and employer contribution limits are $54,000. Employees age 50 and up are entitled to an additional contribution of $6,000, bringing the maximum contribution to $60,000.

A cash balance plan is a little different. It is a defined benefit plan, like a pension, with an employer contribution aspect, the opportunity for an employee contribution and a payout that has the feel of a 401(k). Unlike with a pension, the amount of the payout is stated as an account balance rather than as a monthly income stream. This is why a cash balance pension plan is often called a "hybrid" plan. Just like pension distributions, cash balance distributions at retirement age are taxed at the taxpayer’s ordinary tax rate.

How do cash balance plans work?

In a typical cash balance plan, the participant’s account is credited each year with a "pay credit" from the employer. For example, this could be 5% to 7% of compensation as specified by the employer. Also, the participant’s account receives an "interest credit." The plan can be offered as either a fixed rate or a variable rate that links to an index such as a Treasury note.

Annual increases or decreases in the overall value of the plan's investments do not directly affect the benefit amounts promised to participants. So, if the actual rate of return on plan assets varies from the expected rate, the employer contributions will be adjusted. Accordingly, the investment risks are solely the responsibility of the employer.

When a plan participant becomes entitled to receive benefits, they are expressed in terms of an account balance. For example, let's assume that a participant has an account balance of $250,000 at age 65. Should the employee retire, he or she would have the right to an annuity based on that account balance. Such an annuity might be approximately $20,000 per year for life.

However, many cash balance pension plans allow the participant to choose to take a lump sum benefit instead equal to the account balance. If a retiree receives a lump sum, that distribution can typically be rolled over into an IRA or to another employer plan (if that plan accepts rollovers).

How are cash balance pension plans different from traditional pension plans?

Both traditional defined benefit plans (pensions) and cash balance plans are required to offer payment of an employee's benefit in the form of a series of payments for life (like an annuity). For traditional defined benefit plans, the payments would begin at retirement.

But cash balance plans define the benefit in terms of a stated account balance. These accounts are usually referred to as "hypothetical accounts," because they do not reflect the actual contributions to the account. They merely state an account balance pursuant to the plan document.

Cash balance plans are not just for large companies. In fact, they work great for owner-only businesses and small employers (fewer than 20 employees). However, they are a little more complex to establish. The plan needs to be set up by a third-party administrator and reviewed at least annually by an actuary.

Why is a cash balance pension plan the ultimate tax and retirement strategy?

Simply put, it allows the plan participant to contribute a substantial amount into retirement and take a significant tax deduction. Contribution limits are indexed annually and are based on age. For 2017, participants who are ages 50 and 60 can contribute up to $141,000 and $241,000, respectively. This compares favorably to the $60,000 annual limitation of a 401(k) plan.

Let's look at an example. Assume a 55-year-old physician earns $500,000 a year and is looking to maximize a retirement contribution. Let's also assume, for the sake of simplicity, that the doctor has no qualifying full-time employees (if the doctor had employees they could be subject to small contributions under the plan).

Because of his age and compensation, this doctor could contribute approximately $220,000 into a cash balance plan in year one. If the cash balance plan combines with a solo 401(k) that has a profit-sharing component, the doctor can contribute an additional $37,000. (A 401(k) limit is normally $60,000, but when combined with a cash balance plan it is limited to the $24,000 employee deferral plus 6% of $220,000.) The physician now has a total of $257,000.

This contribution is fully deductible for income tax purposes. Also, substantially all of the contributions can be made up to the date the tax return is filed (including extensions). Assuming a tax rate of 40%, this is a tax saving of $102,000. Not too bad. This amount will grow tax deferred, but will be subject to taxation at his (presumably lower) tax rate in retirement.

Consider the above example of the physician. As you can see, there just are not many retirement options that will allow for such a significant contribution. A 401(k) plan will not come close in this situation.

Cash balance plans are great for: (1) companies with historically consistent profits; (2) professional service businesses (attorneys, physicians, etc.); (3) businesses interested in improving morale and employee retention; (4) owners who fell behind on retirement savings and are looking to “catch-up”; and (5) owners looking to maximize income tax deductions. If you think a cash balance pension plan is right for you, make sure that you review your situation with your CPA and a third-party administrator. Hopefully, the cash balance plan becomes a significant tool in your retirement arsenal.


This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.

Paul Sundin, CPA
Partner, Sundin and Fish, PLC

Paul Sundin is a CPA and tax strategist. With a worldwide client base, he specializes in tax planning and tax structuring for individuals, entrepreneurs and the real estate industry. In addition to being a CPA, he is also an author, speaker and consultant. His professional mission is to educate taxpayers on tax strategies and personal finance.