The SECURE Act and Your Retirement Savings

The Setting Every Community Up for Retirement Enhancement (SECURE) Act was enacted in December 2019 as part of a larger federal spending package. This long-awaited legislation expands savings opportunities for workers and includes new requirements and incentives for employers that provide retirement benefits. At the same time, it restricts a popular estate planning strategy for individuals with significant assets in IRAs and employer-sponsored retirement plans.

Here are some of the changes that may affect your retirement, tax, and estate planning strategies. All of these provisions were effective January 1, 2020, unless otherwise noted.

Benefits for Retirement Savers

Later RMDs. Individuals born on or after July 1, 1949, can wait until age 72 to take required minimum distributions (RMDs) from traditional IRAs and employer-sponsored retirement plans instead of starting them at age 70½ as required under previous law. This is a boon for individuals who don’t need the withdrawals for living expenses, because it postpones payment of income taxes and gives the account a longer time to pursue tax-deferred growth. As under previous law, participants may be able to delay taking withdrawals from their current employer’s plan as long as they are still working.

No traditional IRA age limit. There is no longer a prohibition on contributing to a traditional IRA after age 70½ — taxpayers can make contributions at any age as long as they have earned income. This helps older workers who want to save while reducing their taxable income. But keep in mind that contributions to a traditional IRA only defer taxes. Withdrawals, including any earnings, are taxed as ordinary income, and a larger account balance will increase the RMDs that must start at age 72.

Tax breaks for special situations. For the 2019 and 2020 tax years, taxpayers may deduct unreimbursed medical expenses that exceed 7.5% of their adjusted gross income. In addition, withdrawals may be taken from tax-deferred accounts to cover medical expenses that exceed this threshold without owing the 10% penalty that normally applies before age 59½. (The threshold returns to 10% in 2021.) Penalty-free early withdrawals of up to $5,000 are also allowed to pay for expenses related to the birth or adoption of a child. Regular income taxes apply in both situations.

Tweaks to promote saving. To help workers track their retirement savings progress, employers must provide participants in defined contribution plans with annual statements that illustrate the value of their current retirement plan assets, expressed as monthly income received over a lifetime. Some plans with auto-enrollment may now automatically increase participant contributions until they reach 15% of salary, although employees can opt out. (The previous ceiling was 10%.)

More part-timers gain access to retirement plans. For plan years beginning on or after January 1, 2021, part-time workers age 21 and older who log at least 500 hours annually for three consecutive years generally must be allowed to contribute to qualified retirement plans. (The previous requirement was 1,000 hours and one year of service.) However, employers will not be required to make matching or nonelective contributions on their behalf.

Benefits for Small Businesses

In 2019, only about half of people who worked for small businesses with fewer than50 employees had access to retirement benefits.1 The SECURE Act includes provisions intended to make it easier and more affordable for small businesses to provide qualified retirement plans.

The tax credit that small businesses can take for starting a new retirement plan has increased. The new rule allows a credit equal to the greater of (1) $500 or (2) $250 times the number of non–highly compensated eligible employees or $5,000, whichever is less. The previous credit amount allowed was 50% of startup costs up to $1,000 ($500 maximum credit). There is also a new tax credit of up to $500 for employers that launch a SIMPLE IRA or 401(k) plan with automatic enrollment. Both credits are available for three years.

Effective January 1, 2021, employers will be permitted to join multiple employer plans (MEPs) regardless of industry, geographic location, or affiliation. “Open MEPs,” as they have become known, enable small employers to band together to provide a retirement plan with access to lower prices and other benefits typically reserved for large organizations. (Previously, groups of small businesses had to be related somehow in order to join an MEP.) The legislation also eliminates the “one bad apple” rule, so the failure of one employer in an MEP to meet plan requirements will no longer cause others to be disqualified.

Goodbye Stretch IRA

Under previous law, nonspouse beneficiaries who inherited assets in employer plans and IRAs could “stretch” RMDs — and the tax obligations associated with them — over their lifetimes. The new law generally requires a beneficiary who is more than 10 years younger than the original account owner to liquidate the inherited account within 10 years. Exceptions include a spouse, a disabled or chronically ill individual, and a minor child. The 10-year “clock” will begin when a child reaches the age of majority (18 in most states).

This shorter distribution period could result in bigger tax bills for children and grandchildren who inherit accounts. The 10-year liquidation rule also applies to IRA trust beneficiaries, which may conflict with the reasons a trust was originally created.

In addition to revisiting beneficiary designations, you might consider how IRA dollars fit into your overall estate plan. For example, it might make sense to convert traditional IRA funds to a Roth IRA, which can be inherited tax-free (if the five-year holding period has been met). Roth IRA conversions are taxable events, but if converted amounts are spread over the next several tax years, you may benefit from lower income tax rates, which are set to expire in 2026.

If you have questions about how the SECURE Act may impact your finances, this may be a good time to consult your financial, tax, and/or legal professionals.

Jason C. Luders

319.266.6156

1) U.S. Bureau of Labor Statistics, 2019

This information is not intended as tax, legal, investment, or retirement advice or recommendations, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek advice from an independent tax or legal professional. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Broadridge Advisor Solutions. © 2020 Broadridge Investor Communication Solutions, Inc.

What Is a Roth 401(k)?

The arena of employer-sponsored retirement plans has been dominated by 401(k) plans that are funded with pre-tax contributions, which effectively defers taxes until distributions begin. However, Roth 401(k) is funded with after-tax money just like a Roth IRA, allowing retirees to enjoy qualified tax-free distributions once they reach age 59½ and have met the five-year holding requirement.

It might be smart to invest in a Roth 401(k) if you believe that you will be in a higher tax bracket during retirement. This is always a possibility, especially if you end up with fewer tax deductions during your post-working years. On the other hand, if you expect to be in a lower tax bracket during retirement, then deferring taxes by investing in a traditional 401(k) may be the answer for you. If you have not been able to contribute to a Roth IRA because of the income restrictions, you will be happy to know that there are no income limits with a Roth 401(k).

Employers may match employee contributions to a Roth 401(k) plan, but any matching contributions must go into a traditional 401(k) account. That is, employer contributions and any earnings are always made on a pre-tax basis, and are taxable when distributed from the plan.

If an employer offers a Roth 401(k) plan, employees have the option of contributing to either the regular (pre-tax) or the Roth account, or even both at the same time. If you do not know which type of account would be better for your financial situation, you might split your contributions between the two types of plans. It’s important to note that in 2020, your combined annual contributions to a 401(k) plan cannot exceed $19,500 (up from $19,000 in 2019) if you are under age 50, or $26,000 (up from $25,000 in 2019) if you are 50 or older. These amounts are indexed annually for inflation.

If your employer offers a Roth 401(k) plan and allows in-plan Roth conversions, you can make transfers to a Roth 401(k) account at any time. Conversion is a taxable event. Funds converted are taxed as ordinary income in the year of the conversion.

Upon separation of service, you can roll over your Roth 401(k) assets to another Roth 401(k), a Roth 403(b), or a Roth IRA. Assets cannot be rolled over to a traditional 401(k) account. If you transition from an employer that offers a Roth 401(k) account to an employer that does not, your only option would be to roll the assets directly to a Roth IRA or to leave your money in your former employer’s plan (if allowed).

The required minimum distribution guidelines of a Roth 401(k) work like those of traditional 401(k) plans. You must generally begin taking distributions after reaching age 70½, either as a lump sum or on a required minimum distribution schedule based on your life expectancy. However, unlike traditional 401(k) withdrawals, Roth distributions would be free of federal income taxes.

If you see the advantages of having tax-free income in retirement, then you might consider a Roth 401(k). It allows you to contribute more annually than you could to an IRA, and the tax-free distributions won’t add to your income tax liability. Of course, before taking any specific action, you might want to consult with your tax professional.

The information in this newsletter is not intended as tax, legal, investment, or retirement advice or recommendations, and it may not be relied on for the ­purpose of ­avoiding any ­federal tax penalties. You are encouraged to seek advice from an independent professional ­advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the ­purchase or sale of any security. This material was written and prepared by Broadridge Advisor Solutions. © 2020 Broadridge Investor Communication Solutions, Inc.

Taking a Team Approach to Retirement Savings

Now that it’s common for families to have two wage earners, many married couples accumulate assets in separate accounts. They might each have savings in an employer-sponsored plan and perhaps one or more IRAs as well.

Even when most of a couple’s retirement assets reside in different accounts, it’s still possible to craft a unified savings and investment strategy. Communication and teamwork are good for a marriage in general, and working together could help create a stronger financial future.

Mars and Venus

Research has consistently shown that men and women have different investment approaches. Individual strategies vary, of course, but in general men tend to be more aggressive and trade more frequently, while women tend to be more methodical and embrace a buy-and-hold strategy.1

Over the long term, women may be more successful investors — one study found that their returns outpaced men’s by about 0.4%, while another found a difference of 1.2%.2 But women do not invest as much or as early in their lives and may be overly cautious. A recent survey found that women keep more assets in cash than men do, which will result in the loss of purchasing power over time.3

Shared Strategies

These differences suggest that a married couple might have much to gain by discussing their goals and philosophies for savings and investments, and by considering their accounts holistically. This does not mean that every decision must be made together. But it could be helpful to look together at the larger picture.

Owning and managing separate portfolios allows each spouse to choose investments based on his or her individual risk tolerance. Some couples may prefer to maintain a high level of independence for this reason, especially if one spouse is more comfortable with market volatility than the other. Employing different investment strategies might also increase the diversification of family assets as long as the approaches are not completely contradictory.

On the other hand, coordinating investments might help some families build more wealth over time. For example, one spouse’s employer may offer a better match for employee contributions, so it might be wise to prioritize contributions to that plan in order to obtain the full match. One workplace plan might offer a broader and/or more appealing selection of investment options, while the offerings in another plan may be limited. With a joint strategy, both spouses agree on an appropriate asset allocation for their combined savings, and their contributions are invested in a way that takes advantage of each plan’s strengths while avoiding any weaknesses.

Whether you make investment decisions separately for individual accounts or share decisions for all of your accounts, keep in mind that retirement assets generally belong to both of you. You may benefit by talking as a couple with your financial advisor.

Asset allocation and diversification are methods to help manage investment risk; they do not guarantee a profit or protect against loss. Although there is no assurance that working with a financial professional will improve investment results, a professional who focuses on your overall financial objectives can help you consider strategies that could have a substantial effect on your long-term financial situation.

1–2) Investor’s Business Daily, July 16, 2018
3) Money, February 12, 2018

This information is not intended as tax, legal, investment, or retirement advice or recommendations, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Broadridge Advisor Solutions. © 2019 Broadridge Investor Communication Solutions, Inc.

Doubling Your Money

How Long Will It Take to Double My Money?
Before making any investment decision, one of the key elements you face is working out the real rate of return on your investment.

Compound interest is critical to investment growth. Whether your financial portfolio consists solely of a deposit account at your local bank or a series of highly leveraged investments, your rate of return is dramatically improved by the compounding factor.

With simple interest, interest is paid just on the principal. With compound interest, the return that you receive on your initial investment is automatically reinvested. In other words, you receive interest on the interest.

But just how quickly does your money grow? The easiest way to work that out is by using what’s known as the “Rule of 72.”1 Quite simply, the “Rule of 72” enables you to determine how long it will take for the money you’ve invested on a compound interest basis to double. You divide 72 by the interest rate to get the answer.

For example, if you invest $10,000 at 10 percent compound interest, then the “Rule of 72” states that in 7.2 years you will have $20,000. You divide 72 by 10 percent to get the time it takes for your money to double. The “Rule of 72” is a rule of thumb that gives approximate results. It is most accurate for hypothetical rates between 5 and 20 percent.

While compound interest is a great ally to an investor, inflation is one of the greatest enemies. The “Rule of 72” can also highlight the damage that inflation can do to your money.

Let’s say you decide not to invest your $10,000 but hide it under your mattress instead. Assuming an inflation rate of 4.5 percent, in 16 years your $10,000 will have lost half of its value.

The real rate of return is the key to how quickly the value of your investment will grow. If you are receiving 10 percent interest on an investment but inflation is running at 4 percent, then your real rate of return is 6 percent. In such a scenario, it will take your money 12 years to double in value.

The “Rule of 72” is a quick and easy way to determine the value of compound interest over time. By taking the real rate of return into consideration (nominal interest less inflation), you can see how soon a particular investment will double the value of your money.

The Rule of 72 is a mathematical concept, and the hypothetical return illustrated is not representative of a specific investment. Also note that the principal and yield of securities will fluctuate with changes in market conditions so that the shares, when sold, may be worth more or less than their original cost.The Rule of 72 does not include adjustments for income or taxation. It assumes that interest is compounded annually. Actual results will vary.

The information in this newsletter is not intended as tax, legal, investment, or retirement advice or recommendations, and it may not be relied on for the ­purpose of ­avoiding any ­federal tax penalties. You are encouraged to seek advice from an independent professional ­advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the ­purchase or sale of any security. This material was written and prepared by Broadridge Advisor Solutions. © 2019 Broadridge Investor Communication Solutions, Inc.

Roth 401(K)

What Is a Roth 401(k)?
The arena of employer-sponsored retirement plans has been dominated by 401(k) plans that are funded with pre-tax contributions, which effectively defers taxes until distributions begin. However, Roth 401(k) is funded with after-tax money just like a Roth IRA, allowing retirees to enjoy qualified tax-free distributions once they reach age 59½ and have met the five-year holding requirement.

It might be smart to invest in a Roth 401(k) if you believe that you will be in a higher tax bracket during retirement. This is always a possibility, especially if you end up with fewer tax deductions during your post-working years. On the other hand, if you expect to be in a lower tax bracket during retirement, then deferring taxes by investing in a traditional 401(k) may be the answer for you. If you have not been able to contribute to a Roth IRA because of the income restrictions, you will be happy to know that there are no income limits with a Roth 401(k).

Employers may match employee contributions to a Roth 401(k) plan, but any matching contributions must go into a traditional 401(k) account. That is, employer contributions and any earnings are always made on a pre-tax basis, and are taxable when distributed from the plan.

If an employer offers a Roth 401(k) plan, employees have the option of contributing to either the regular (pre-tax) or the Roth account, or even both at the same time. If you do not know which type of account would be better for your financial situation, you might split your contributions between the two types of plans. It’s important to note that in 2019, your combined annual contributions to a 401(k) plan cannot exceed $19,000 if you are under age 50, or $25,000 if you are 50 or older. These amounts are indexed annually for inflation.

If your employer offers a Roth 401(k) plan and allows in-plan Roth conversions, you can make transfers to a Roth 401(k) account at any time. Conversion is a taxable event. Funds converted are taxed as ordinary income in the year of the conversion.

Upon separation of service, you can roll over your Roth 401(k) assets to another Roth 401(k), a Roth 403(b), or a Roth IRA. Assets cannot be rolled over to a traditional 401(k) account. If you transition from an employer that offers a Roth 401(k) account to an employer that does not, your only option would be to roll the assets directly to a Roth IRA or to leave your money in your former employer’s plan (if allowed).

The required minimum distribution guidelines of a Roth 401(k) work like those of traditional 401(k) plans. You must generally begin taking distributions after reaching age 70½, either as a lump sum or on a required minimum distribution schedule based on your life expectancy. However, unlike traditional 401(k) withdrawals, Roth distributions would be free of federal income taxes.

If you see the advantages of having tax-free income in retirement, then you might consider a Roth 401(k). It allows you to contribute more annually than you could to an IRA, and the tax-free distributions won’t add to your income tax liability. Of course, before taking any specific action, you might want to consult with your tax professional.

The information in this newsletter is not intended as tax, legal, investment, or retirement advice or recommendations, and it may not be relied on for the ­purpose of ­avoiding any ­federal tax penalties. You are encouraged to seek advice from an independent professional ­advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the ­purchase or sale of any security. This material was written and prepared by Broadridge Advisor Solutions. © 2019 Broadridge Investor Communication Solutions, Inc.

Medicare Open Enrollment

Medicare Open Enrollment: Time to pick a plan

Medicare Open Enrollment is here and runs until December 7! We know many people find and compare health plans at Medicare.gov during Open Enrollment. This year we’ve made some improvements to provide you with more personalized help with your plan choices.

We’ve added a simplified log in option through your MyMedicare.gov account, for a more personalized experience. You also can still log in with your Medicare number and a little more information or do a general search of Medicare plans by entering just a ZIP code. If you’re comparing plans through your MyMedicare account and need help or have a question, you can access our new web chat feature to connect with a customer service representative online and get answers right away. Watch a video about these improvements to help you find the right plan for you.

Picking a plan is an important and personal decision. Here are some things to think about as you compare Medicare plans to find one that meets your needs:

Does the plan cover the services you need?

Think about what services and benefits you’re likely to use in the coming year and find coverage that meets your needs. If you have other types of health or prescription drug coverage, make sure you understand how that coverage works with Medicare. And, if you travel a lot, check to make see if your plan covers you when you’re away from home.

What does the plan cost?

The lowest-cost health plan option might not be the best choice for you – consider things like the cost of premiums and deductibles, how much you pay for hospital stays and doctor visits, and whether it’s important for you to have expenses balanced throughout the year.

Are the plan’s providers and rules convenient?

Your time is valuable. Where are the doctors’ offices? What are their hours? Which pharmacies can you use? Can you get prescriptions by mail? Do the doctors use electronic health records or prescribe electronically? Answers to these questions may help you decide which plan is best for you.

What plans perform the best?

Not all health care is created equal, and the doctors, hospitals and facilities you choose can affect your health. Open Enrollment is also a good time to ask yourself whether you’re truly satisfied with your medical care. Look for plans with a 5‑star performance rating—the right expertise and care can make a difference.

Remember that even if you’re happy with your current plan, things change from year to year—so it’s important to take the time to compare.

Courtesy www.Medicare.Gov

Choosing the Correct Survivor Annuity

Retirement and life insurance aren’t commonly thought of together, yet that is exactly what the survivor annuity is. The FERS survivor annuity (SA) is an option that FERS employees can elect on their retirement paperwork.

Why is a survivor annuity like life insurance?

The main purpose for a survivor annuity is for married FERS employees to have the option to leave an income stream to their surviving spouse. In other words, you can leave a benefit at your death (sound familiar?). The reason for the SA is quite simple – many spouses can’t afford to lose an income of $2,000 a month (I will repeatedly use the example of a $2,000 monthly FERS annuity in this article).

This is a VERY important subject (albeit not the most pleasant to discuss) and an important conversation to have.

There are actually three options on your retirement paperwork regarding your SA choice.

  • No survivor
  • Partial survivor
  • Full survivor

No survivor annuity

If you don’t choose a survivor annuity, your paperwork has to be signed and notarized by your spouse. The only thing your spouse would receive under this option is a refund of any unused FERS deposits (The total of the 0.8% you paid in minus the total of FERS benefits received). If you don’t choose a SA then your spouse cannot continue Federal Employee Health Benefits (FEHB) after your death.

Partial Survivor Annuity

The partial SA will reduce your annuity by 5% in return for a spousal benefit of 25% at your death. Using our example of a $2,000 annuity, the federal retiree’s FERS annuity would be $1,900 a month and guarantee that their spouse will receive $500 a month (if the spouse is still living after the federal employee’s death).

Your spouse’s signature and notarization are required for the partial annuity as well.

The partial SA does allow your spouse to continue FEHB after your death.

Full Survivor Annuity

The full SA will reduce your annuity by 10% in return for a spousal benefit of 50% at your death. Going back the example of $2,000, your FERS annuity would be $1,800 a month and your surviving spouse would receive $1,000 a month after your death.

A great deal of talk about death and dying here, but what happens if the federal employee outlives the spouse? First, the federal employee needs to notify OPM of the spouse’s death in order to get your annuity changed back to 100%.

You will not get the 5%, or 10% back that you paid in for the survivor annuity. Any past reduction in your FERS annuity will be lost.

COLA on the survivor annuity

Another important aspect of the survivor annuity is that there is a default COLA associated with it. Since FERS annuitants over age 62 receive a COLA on their annuity, that means that the survivor annuity will increase along with that COLA. As the FERS annuity increases, so does the survivor benefit.

This is both good and bad – yes, the survivor annuity will increase each time you receive a COLA but so does the cost. For example, a full survivor annuity costs a retiree 10% of their FERS annuity and 10% of $2,500 is less than 10% of $3,000.

Is life insurance a good replacement for the survivor annuity?

As is the case with many financial questions, it depends on a few factors.

The first question to answer is whether or not your spouse depends on your health insurance. I would guesstimate that this is the case with 90% of federal employees, and if so then you must elect a survivor annuity. In this scenario, the most you could do is look at getting life insurance to cover over and above the partial SA.

Something else to consider is taxes. The cost of the survivor annuity is not taxed, but the premiums for life insurance are made in after tax dollars. The opposite is true of the benefits of each. Survivor annuities are taxable income and life insurance proceeds are income tax free.

The age and health of each spouse needs to be considered as well. If your spouse is 10 years older and in bad health, life insurance may be a good fit versus the SA. If you are 10 years older than your spouse, then the SA sounds like a good deal because your insurance costs may be high and your spouse will likely outlive you and benefit from the guaranteed SA.

Is leaving money to your kids a priority? If so, then life insurance could be a good fit since it will pay out at your death regardless of who outlives who. This is not the case with the survivor annuity. The survivor annuity is only around for a maximum of your lifetime and your spouse’s lifetime.

If you are single at retirement and get married later, there are options for adding your spouse to your benefits and electing a SA for your new spouse. You must notify OPM and they will help you through the details.

Important decision

The survivor annuity is no different than any other retirement decision – it is going to take a little thought and analysis to make the best decision for you and your family. Survivor annuity elections are one point of analysis in our financial plans with federal employees. If you would like to discuss putting together your own plan you are welcome to set up an introductory call.

Retirement Plan Limits

How much money can I put into my IRA or employer-sponsored retirement plan?

IRAs and employer-sponsored retirement plans are subject to annual contribution limits set by the federal government. The limits are adjusted periodically to compensate for inflation and increases in the cost of living.

IRAS

For the 2016 and 2017 tax years, you can contribute up to $5,500 to all IRAs combined (the limit is adjusted annually for inflation). If you have a traditional IRA as well as a Roth IRA, you can only contribute a total of the annual limit in one year, not the annual limit to each.

If you are age 50 or older, you can also make a $1,000 annual “catch-up” contribution.

EMPLOYER-SPONSORED RETIREMENT PLANS

Employer-sponsored retirement plans such as 401(k)s and 403(b)s have an $18,000 contribution limit in 2017 (unchanged from 2016); individuals aged 50 and older can contribute an extra $6,000 each year as a catch-up contribution. (Section 403(b) and 457(b) plans may also provide special catch-up opportunities.)

SIMPLE PLANS

You can contribute up to $12,500 to a SIMPLE IRA or SIMPLE 401(k) plan in 2017, and an extra $3,000 catch-up contribution if you are age 50 or older (unchanged from 2016).

Distributions from traditional IRAs and most employer-sponsored retirement plans are taxed as ordinary income, except for any after-tax contributions you’ve made, and the taxable portion may be subject to 10% federal income tax penalty if taken prior to reaching age 59½ (unless an exception applies). If you participate in both a traditional IRA and an employer-sponsored plan, your IRA contributions may or may not be tax deductible, depending on your adjusted gross income.

 

The information in this newsletter is not intended as tax, legal, investment, or retirement advice or recommendations, and it may not be relied on for the purpose of avoiding any federal tax penalties. You are encouraged to seek advice from an independent professional advisor. The content is derived from sources believed to be accurate. Neither the information presented nor any opinion expressed constitutes a solicitation for the purchase or sale of any security. This material was written and prepared by Broadridge Advisor Solutions. © 2017 Broadridge Investor Communication Solutions, Inc.

Cash Balance Plans

Cash Balance Plans Can Help Supercharge Retirement Savings

Cash balance plans are technically defined benefit plans that share some characteristics with defined contribution plans. IRS regulations finalized in 2010 and 2014 clarified some legal issues and made these hybrid plans more flexible and appealing to employers. Nationwide, there was a 189% increase in new cash balance plans between 2008 and 2014.1

Cash balance plans are not just a powerful tool for employee recruitment and retention. They have generous contribution limits that increase with age, and they’re often combined with a 401(k) or profit-sharing plan. This might allow partners in professional service firms and other high-income business owners to maximize or catch up on retirement savings and reduce their taxable income.

In 2016, a 65-year-old could save as much as $245,000 in a cash balance plan, while a 55-year-old could save $180,000 on a tax-deferred basis (until the account reaches a maximum accumulation of $2.5 million).2

Assuming the Risk

As with other defined benefit plans, employees are promised a specified retirement benefit, and the employer is responsible for funding the plan and selecting investments. However, each participant has an individual (albeit hypothetical) account with a “cash balance” for record-keeping purposes, and the vested account value is portable, which means it can be rolled over to another employer plan or to an IRA.

But unlike the situation with a 401(k), the participant’s cash balance when benefit payments begin can never be less than the sum of the contributions made to the participant’s account, even if plan investments result in negative earnings for a particular period. This means the employer bears all the financial risks.

Funding the Plan

Each year, the employer makes two contributions to the cash balance plan for each employee. The first is a pay credit, which is either a fixed amount or a percentage of annual compensation. The second contribution is a fixed or variable interest credit rate (ICR). The ICR can be set to equal the actual rate of return of the portfolio, if certain diversification requirements are met, which reduces the employer’s investment risk and the possibility of having an underfunded plan due to market volatility.

Weighing the Cost

The amount that the employer must contribute to the plan each year is actuarially determined based on plan design and worker demographics. Typically, IRS rules require owners to contribute 5% to 8% of pay to non-highly compensated employees in order to make larger tax-deferred contributions for themselves.3

Businesses may take a significant tax deduction for employee contributions, so current-year tax savings may offset some of these costs. Still, cash balance plans are typically more cost-effective if you are a sole proprietor or the owner of a small firm with just a few employees.