Interview: How to significantly reduce taxes while saving for retirement

By Jenny LescohierJuly 06, 2021

Scott Poulin, Calamos Wealth Management Investments

Many business owners and entrepreneurs are beginning to recover from setbacks due to the global pandemic crisis and seeking ways to maximize their retirement plan savings during what continues to be one of the longest bull markets in U.S. history.

Cash balance pension plans have soared in popularity in response to those needs but many remain unaware of their existence and the benefits they can offer. We talked with Scott Poulin with Calamos Wealth Management to help shed some light on how they work.

CONEXPO-CON/AGG 365: What is a cash balance pension plan and why is it gaining popularity among construction business owners?

Scott Poulin, Calamos Wealth Management: Every business owner is looking for opportunities to save money, particularly for retirement, and ideally on a pre-tax basis, much like you would do in a traditional 401k retirement plan.

The problem with a 401k is you can only contribute $19,500 per year as an individual, unless you’re over the age of 50 and are eligible for the make-up provision of $6,500 which allows for a total of a $26,000 annual contribution.

For the business owner, a traditional 401k gives them that potential $26,000 income reduction, which is nice, but it’s not going to set the world on fire. Business owners often say, what other tools are available so I can put more money into a retirement plan?

A cash balance pension plan, if designed correctly, allows the business owner to reap the majority of the economic benefit from a company retirement plan. It’s truly designed for the entrepreneur business owner.

CONEXPO-CON/AGG 365: How does it work?

Poulin: How much can be contributed per year depends upon the age of the business owner and employees, as well as the participants’ proximity to retirement age and salary.

If the business owner is over the age of 60, the contribution going into the plan can be up to $261,000 per year. Think about that: Would you rather have a plan that allows a $26,000 contribution or one that allows $261,000?

These are employer-sponsored plans so they’re business expenses incurred on a pre-tax basis. If you’re a business owner, and you have $1 million worth of revenue, and you’re contributing $261,000 to the plan, your revenue minus expenses is your net income, and you pay taxes on the net income, so yes, it’s an opportunity to reduce the amount you pay in taxes.

With a cash balance pension plan, we reduce the business owner’s net income by $261,000. Additionally, that $261,000 annual contribution grows tax deferred.

These plans are also 100% creditor protected. So if somebody sues you, they can’t take that money.

CONEXPO-CON/AGG 365: How do employees benefit?

Poulin: We design the plan such that we’re putting away as much as we can for the business owner, and whatever is necessary for the employees, such that the plan does not fail any discriminatory testing.

Similar to traditional defined benefit plans, employers make contributions for the benefit of each employee. However, instead of using an actuarial rate of return, the employer makes two contributions 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 an interest credit rate (ICR), which is typically set to equal the actual rate of return of the portfolio, thereby reducing the investment risk of market volatility and the possibility of having an underfunded plan.

Another defining difference is that a hypothetical account is maintained for each employee. Contributions are recorded into these accounts, providing the employee with the ability to understand their benefit as a hypothetical account balance, similar to a 401k account, instead of a specific monthly benefit upon retirement.

To maximize their effectiveness, 96% of cash balance pension plans are combined with 401k, profit sharing and other defined contribution plans. This allows for plans that are maximized for the benefit of the business owner while also helping to recruit and retain employees.

CONEXPO-CON/AGG 365: What’s the catch?

Poulin: There are some downsides, but nothing that’s insurmountable. For example, when you go into a plan like this, you need to commit to funding it at a set level for at least three years.

I like to tell clients, there’s a fine line between tax avoidance and tax evasion; this plan is a tax avoidance technique. You’re legally avoiding paying taxes because you’re putting money into a retirement plan. Once we design the plan and the business owner says okay, I can afford to contribute $261,000 per year, then he or she must commit to that for the next three years.

If you are a serial modifier of your retirement contributions, you might say, Scott, I had a bad year. I can’t do the $261,000 this year. Fortunately, the Federal government isn’t so callous that they’re going to put cement shoes on you. You can reduce your contribution down to something that is more doable - let’s say down to $100,000 - but then you’re stuck at that lower level for the next three years.

What the feds don’t want you doing is trying to go back to $261,000 in that third year. You cannot do that. This is a plan that’s really designed for companies that have consistent and predictable earnings.

CONEXPO-CON/AGG 365: How does the interest credit rate work?

Poulin: A cash balance plan is based upon the age of the participants, the expected retirement age and salary as well as some other actuarial assumptions, including a rate of return called an interest credit rate.

Most actuaries use a fixed rate of 4% or 5%. If you have $1 million in the plan right now, the actuary calculates that you need to give $100,000. When you do, the plan is then worth $1.1 million. The actuary then calculates that by the end of the year, assuming a 5% return, it should grow by $55,000 to $1,155,000.

What happens if you don’t get to 5%? What happens if the return is actually zero? You end the year and you’re supposed to have $1,155,000 but you end up with only $1,100,000? This is called being underfunded and by law, the business owner needs to come up with the shortfall.

The business owner normally doesn’t complain, because he or she realizes if they put that $55,000 in, it reduces their taxes even more. But what if the amount is $220,000? Not many companies can just write a check for $220,000.

CONEXPO-CON/AGG 365: Is there a way around that?

Poulin: Yes, there is. In 2016, the Department of Labor clarified the rules on the interest credit rate and you’re now allowed to have an interest credit rate equal to the actual rate of return, provided the money was appropriately diversified. After 2008, when the market really took a downturn, the interest credit rate was 8% to 10%. But what diversified portfolio was consistently getting 8% or 10% return?

There was a lot of discussion and a lot of lobbying going back and forth and ultimately, the people in Washington want the American population to save more for retirement on their own so they’re less dependent on Social Security. One of the reasons why people were not using the cash balance plan is because the interest credit rate was set far too high and not consistently attainable.

CONEXPO-CON/AGG 365: What happens when the plan runs its course?

Poulin: Remember, this money isn’t tax free. When the plan ends as the business owner retires, the money gets rolled into an IRA, and at that point it’s subject to those rules and requirements for distributions.

Bottom line, this money will eventually be taxed, ideally at a lower rate when the participants are retired. In the meantime it’s simply growing tax deferred.

CONEXPO-CON/AGG 365: What size company does this type of plan make the most sense for?

Poulin: Companies with 100 employees or less now represent 94% of all cash balance pension plans, and nearly 59% of all cash balance plans are sponsored by employers with fewer than 10 employees.

At a glance: Benefits of cash balance pension plans to business owners

  • Not all participants are equal – plans can be designed to maximize benefits to owners, while minimizing contributions to other employees. Since contributions are age-based, older business owners may be able to contribute as much as $261,000 annually and reap upwards of 90% of the benefits of the plan.
  • Income tax reduction strategies – contributions to retirement plans reduce your taxable income dollar for dollar.
  • Asset protection – all qualified pension plans are protected under the Employee Retirement Income Security Act of 1974 (ERISA). The ability to accumulate large sums makes these plans particularly attractive to doctors, lawyers, and entrepreneurs.
  • Eliminate the potential of an underfunded pension liability – regulatory revisions allow the plan’s ICR to equal the plan’s actual rate of return, thereby eliminating a plan’s ability to be underfunded due to market declines. The plan’s assets must be adequately diversified.
  • Federal guarantee – as with all pension plans, cash balance plans can be guaranteed by the Pension Benefit Guaranty Corporation for a nominal fee.
  • Portability and value – IRS regulation allows for a maximum accumulation of $2.5 million. After a three-year vesting period, account values can be rolled over to an Individual Retirement Account (IRA) or a lifetime annuity can be purchased.
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