Investing for retirement can be problematic for professionals in partnerships or other types of closely held firms. These individuals tend to spend their early careers focused on building their business. By the time they are ready to start saving money for retirement, standard retirement saving vehicles such as 401(k) plans can shelter only a small portion of their income. The rest is subject to taxes, often in the highest brackets.
Cash balance plans can help. A type of defined benefit retirement plan, cash balance plans have much higher annual contribution
limits than 401(k)s—nearly 10 times higher for older individuals, enabling participants to build substantial tax-deferred accounts. If individuals earn enough to take advantage of these contributions, they can accumulate secure retirement portfolios much more quickly than with traditional retirement plans. For this reason, the plans tend to be most popular with firms of relatively highly paid professionals, such as law firms, accounting firms, and medical and dental practices—although any type of business may find them attractive.
To get the most out of cash balance plans, firms need to make well-informed decisions about their plans’ terms and investment strategy, which can have a big impact on a plan’s relative success. Too often, firms make these decisions without a full analysis of their ramifications.
The chief attraction of cash balance plans is clear: greater potential for building tax-deferred wealth. By sheltering income from taxes when it is earned and allowing the invested assets to compound without taxes, these plans allow participants’ wealth to grow at a faster rate. If income taxes rise in the near future, as many expect, this tax-deferral feature may become even more attractive. One other attraction of cash balance plans has nothing to do with investment potential. It is the fact that a firm’s defined benefit plan is protected from the firm’s creditors. In today’s litigious world, a cash balance plan is one way to protect partners’ assets.
Cash balance plans are especially popular with professional practices, whether in the fields of law, accounting, medicine, or dentistry. But any closely held business may find the plans appealing, assuming the firm has:
- A 401(k) and/or profit-sharing plan in place. Closely held firms should take full advantage of their ability to create 401(k) plans and/or profit-sharing plans before creating cash balance plans. Although their annual contribution limits are smaller, these types of plans are relatively simple and inexpensive to create.
- Partners with substantial discretionary income to save. Cash balance plans, for the most part, are most effective when partners can take full advantage of their maximum contribution limits.
- Relatively steady cash flow. Once created, cash balance plans require annual contributions, regardless of the company’s fortunes. Unlike 401(k) plans, contributions cannot be suspended in tough times. Therefore, anyone considering a cash balance plan should be relatively confident that there will be sufficient income to support the plan on an ongoing basis.