A Beginner's Guide to Cash Balance Plans

A Beginner’s Guide to Cash Balance Plans

In my financial planning practice I work with a good number of business owners who want to make aggressive contributions to their tax deferred retirement accounts.  This helps put them on strong footing for retirement, but also provides a generous tax deduction.  While the 401k plan is the primary retirement plan most business owners are familiar with, a cash balance plans is one I often recommend in addition.  In fact, cash balance plans can actually allow for far greater contributions & tax advantages.

A cash balance plan could be a good fit if you’d like to contribute over $50,000 per year to a tax advantaged retirement plan.  They don’t come without their nuances though.  This guide will explain how cash balance plans work and whether they might be a good fit for you.

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Investing in Yourself as an Entrepreneur

Investing In Yourself as an Entrepreneur

Many of us feel an innate need to make contributions to tax advantaged retirement plans every year.  When it comes to personal finance, much of what we read, hear, and see in the media centers on plowing money into your 401k every single year, no matter what.

In general it’s great advice.  Save early and often, and take advantaged of tax deferred compound income.  And if you’re lucky, your employer might match your contributions or make a profit sharing contribution.  If we’re going to build up enough savings to sustain our lifestyle through retirement, this makes perfect sense.

Every once in a while I’ll speak with an entrepreneur who is really working hard to build their business, but they can’t quite scratch together enough cash to fund their retirement plan for the year.  They’re putting all their effort into their company and things are still just a bit tight financially.  They feel like they should be contributing to the 401k they set up for themselves and their employees, but they can’t quite pull the funds together to do so.

For many business owners I speak with, the fact that they can’t fund their 401k for the year makes them feel inadequate.  Like they’re not good at their job.  Like they’re unsuccessful.

I wanted to write a post on this topic because entrepreneurs who feel this way are missing the forest from the trees.  Regardless of whether you contribute to a retirement plan in a certain year, it’s far more important to sustain & grow your business.  Because if you can find a way to grow your business each year, the increased value in your ownership stake will dwarf what you could ever contribute to 401k!

 

It’s OK to Skip a Few 401(k) Contributions

Aswath Damodaran is a professor at NYU who teaches corporate finance, investing, and business valuation.  He publishes estimates of EBITDA multiple benchmarks for use by his students, and anyone else who’s interested.  EBITDA is an accounting measure that stands for “earnings before interest, taxes, depreciation, or amortization”.  It’s a decent proxy for free cash flow, and is often used in quick and dirty business valuations.

For example, let’s say your business does $350,000 in revenue one year.  If your costs & operating expenses totaled $250,000, you’d be left with EBITDA of $100,000.  Here are Professor Damodaran’s valuation estimates for 2018.  The list of multiples ranges from 5-6x EBITDA on the low end to nearly 20x on the high end.  Meaning, it’s very possible that a business with $100,000 in recurring annual EBITDA is worth at least $500,000 ($100,000 * 5).

Now, when I mean quick and dirty, this example is very quick, and very dirty.  Business valuation is a field of its own, and not something I claim to be half way competent in.  There are a ton of factors that go into what a business is worth, and EBITDA certainly doesn’t paint the whole picture.  Nevertheless, the takeaway is important: if you can build a business with recurring annual revenue, that will persist even if you’re not around to drive sales, there’s a good chance you’re creating far more wealth than what you would maxing out your 401k contributions.

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What You Need to Know About the SECURE Act Retirement Bill

What You Should Know About the SECURE Act Retirement Bill

Every now and then, lawmakers in Washington make noise about changing various sections of the tax advantaged retirement accounts I’m so fond of recommending to my clients.  Now that we’re living substantially longer, and a greater portion of our lives is actually spent in retirement, there’s a good argument that we should increase age limits, mandatory distributions, and other rules governing IRAs, 401(k)s and other types of accounts.

I usually don’t pay much attention to this speculation until there’s a bill on the floor that has a strong chance of becoming law.  The majority of the legislation drafted in this area doesn’t get far, and often doesn’t even get out of committee.

Nevertheless, the house and senate have both recently introduced bills that would change how retirement accounts work.  I’m no political expert, and don’t have the foggiest idea what the chances are of one of these bills passing.  But from what I’m reading there’s more momentum for retirement reform now than there’s been in the last several years.  Plus, more than one client asked my thoughts on the subject recently so I felt a summary post would be appropriate.  This post will cover what happened & why it might be important to you.

 

Pending Legislation

In February the senate introduced a bill called the “Retirement Enhancement and Savings Act” (or RESA), aimed at fixing America’s retirement savings problems – both in the public and private sectors.  This isn’t the first bill on retirement reform that’s been introduced recently.  Multiple versions containing similar provisions have been introduced since 2016, which speaks to the growing interest in helping Americans save for retirement.

Meanwhile, the house passed the SECURE Retirement bill (Setting Every Community Up for Retirement Enhancement Act) about a week and a half ago in a 417-3 vote.  This bill contains many of the same provisions as RESA, and the bipartisan support on both sides of congress could mean one of the bills may actually make it into law sometime soon.

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Maximizing Your 199a QBI Deduction as a Specialized Service Business

Maximizing Your 199a QBI Deduction as a Specialized Service Business

As you’re probably aware, we’re working with some new tax laws as of January 1st, 2018.  The tax change that will have the most impact for many business owners out there – particularly owners of pass-through businesses – lies in section 199a.

Section 199a specifies that qualified business income is eligible for a 20% across the board deduction on the owners’ personal tax returns.  20%!  This is a big deduction, and falls in line with all the political rhetoric about making the country a more business friendly environment.

Unfortunately, not every business owner will be able to claim it.  One of the more controversial aspects of section 199a is that the deduction phases out at certain levels of taxable income, if your business is considered a “specialized service business” (SSTB).  In 2019, this phaseout range is $315,000 to $415,000 of taxable income for married people filing jointly, and $157,500 to $207,500 for everyone else.

What exactly is a specialized service business, you ask?  It’s one whose principle asset is the skills or experience of one or more professionals.  This includes medicine, law, accounting, financial services, athletics, and several others.

With the introduction of section 199a & the QBI deduction, there are a number of tax planning opportunities for business owners.  Qualifying for the deduction and maximizing its benefit could easily have a significant impact on business owner’s total tax liabilities.  This post will explore three different types of tax planning strategies owners of specialized service businesses may consider to maximize the benefit of the 199a deduction.

 

Income Reduction Strategies

The first, most logical way to maximize the QBI deduction is to find ways to reduce your taxable income.  The lower you are in the phaseout range, the greater portion of the deduction you’ll qualify for.  Note here that the phase out isn’t based on your adjusted gross income or modified adjusted gross income (which is common for most other phaseouts, like IRA/Roth IRA contributions).  The QBI deduction phases out based on your taxable income, which is after you take itemized or standard deductions.  Here are a couple ideas to consider.

 

Qualified Retirement Plan Contributions

Establishing & funding a qualified retirement plan is usually the low hanging fruit for owners of specialized service businesses.  The best plan structure and form for your situation will depend on a number of factors, of course.  And if you have employees, chances are you’ll need to make contributions on their behalf as well.

The usual suspects here are SEP-IRAs & solo 401(k) plans for those without employees, and 401(k) & profit sharing plans for those with employees.  You can also tack on a cash balance plan or defined benefit plan if you want to be aggressive (and are comfortable with mandatory contributions each year).  In either case, every dollar you contribute to a qualified retirement plan, both as an employee deferral or employer contribution, will be deductible.  And, of course, every dollar you deduct gets you one dollar closer to the beginning of the phaseout range.

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Setting Up a 401(k) to Take Advantage of the 'Mega' Back Door Roth Conversion

Setting Up a 401(k) to Take Advantage of the ‘Mega’ Back Door Roth Conversion

If you’re a personal finance nut you may have heard of a strategy called the “back door Roth IRA conversion.”  This maneuver essentially allows you to contribute money to a Roth IRA, even if your income is otherwise to high to make a direct contribution.  You make a non-deductible contribution to a traditional IRA, convert those funds to a Roth IRA, and presto!  You have cash in the Roth that won’t ever be taxed again.  While it seems like this is a glaring loophole in the tax code, Congress has endorsed the strategy in a conference committee report from the Tax Cut & Jobs Act.

But as great as it is to take advantage of Roth IRAs while you’re in high tax brackets, you’re still limited to the annual IRA contribution maximums of $6,000 per year (or $7,000 if you’re 50 or older).  The “Mega” back door Roth conversion is a similar strategy, but allows for up to $37,000 per year in additional Roth contributions using a 401(k) plan.

 

Why the “Mega” Back Door Roth Conversion Strategy Works

 

The Three Types of 401(k) Contributions

To start, let’s review the three types of contributions you could make to a 401(k) plan.  The first is the most common: your employee deferrals.  You can instruct your employee to defer funds from your paycheck and deposit them on your behalf into the company’s 401(k) plan.  Some plans allow you to make these deferrals on a Roth basis, and the limit in 2019 is $19,000 per year.

The second type of contribution is an employer contribution.  This is anything your employer puts into the plan on your behalf, and includes matching contributions, or contributions based on a percentage of your compensation or company profitability.  It may be subject to a vesting schedule, and is always made on a pre-tax basis.

The third, and widely unknown type of contribution is an after-tax deferral.  Some 401(k) plans allow you to make additional contributions beyond your employee deferral on an after-tax basis, once you’ve reached the $19,000 annual limit.  Note here that 401(k) plans are not required to allow this feature, and not all do.

There are two limitations to annual 401(k) contributions.  The first is the $19,000 limit on employee contributions ($25,000 if you’re over 50 years old).  The second is on the total amount contributed to the plan on your behalf.  This limit is $56,000 in 2019, and consists of the three contribution types listed above.

So, to determine how much you could contribute in after-tax deferrals, you’d need to subtract $19,000 (again, $25,000 if you’re over 50) and the total amount of your employer contributions from $56,000.

Theoretically you could make up $37,000 per year in additional Roth IRA contributions using this maneuver ($56,000 – $19,000).  You’d need to be under 50 though, and you couldn’t receive any contributions from your employer.

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A Review of Providence's 457(b) Plan

A Review of Providence’s 457(b) Plan

In my financial planning firm I work mostly with business owners and medical professionals.  A good number of my clients are employees of Providence, which is one of the major medical providers in the Pacific northwest.  Providence offers its employees a very strong benefits & retirement package.  Employees can contribute to a 403(b) plan on a tax-deferred or Roth basis and Providence contributes to a 401(a) plan on their behalf, depending on compensation and years of service.

Providence also offers a 457(b) plan to its employees.  While it’s convenient to have another tax-deferred savings vehicle available, 457 plans come with some quirks – especially surrounding distribution options once you separate from service.

Recently, one my of my clients and I discussed the possibility of them leaving to take another job.  So to wrap our heads around the ins and outs of the 457 plans, we jumped on the phone with one of Providence’s retirement plan administrators.  The administrator helped to explain the unique features of the plan, which I’ll explain in this post.  Hopefully this review is helpful to anyone thinking about participating in Providence’s 457 plan.

 

A Quick Primer on 457(b) Plans

457(b) plans are sometimes mistakenly considered an alternative to a 403(b) plan.  There is actually some nuance to 457(b) plans, and much of it depends on whether the plan is sponsored by a governmental entity.

457(b) plans sponsored by governments have nearly identical rules to 403(b) plans.  The contribution limits are the same, the distribution options & limitations are the same, and by and large the plans operate in the same way.

Non-governmental 457(b) plans are different, in several ways.  Whereas the contribution limits are the same, the distribution options are not.  For non-governmental 457(b) plans, you are not allowed to roll your balances into an IRA.  Yes, you read that correctly.  Whereas participants in government sponsored 457(b) plans may roll their balances into IRAs after separating from service without triggering a taxable event, participants in non-governmental plans may not.

Instead, as a participant in such a plan you’re limited to the unique distribution options of the plan.  This is worth some investigation, as some plans require full distribution shortly after separating from service.  There isn’t an early distribution penalty for withdrawals prior to age 59 1/2, but withdrawals are still taxed as income.  Think about that for a moment.  You participate in a non-governmental 457(b) plan for years, accumulating potentially hundreds of thousands of dollars in the plan.  Then when you separate from service you’re forced to take everything out, and be taxed on it, in one year.

Another unique difference is creditor protection.  Whereas 403(b) and 403(k) plans are held in trust, 457(b) plans are held in the name of the organization sponsoring the plan.  This seems like a subtle difference, but can be impactful in the event of liquidation.  If the sponsoring organization falls into bankruptcy, your assets in the plan would be exposed to creditors.  The chances of this happening are probably quite small (especially for an organization like Providence), but I’m sure that’s what everyone at WorldCom and Enron thought as well.

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Defined Benefits Pension Plan: Helping Business Owners Shelter Thousands from Income Tax

The Defined Benefits Pension Plan: Helping Business Owners Shelter Thousands from Income Tax

Taxes are frustrating to nearly every small business owner I speak with.  Most people agree that we should all pay our fair share.  But after working countless thousands of hours to build a viable business, it’s easy to feel like Uncle Sam’s reaching into our pockets too far.  That’s why I focus on helping my clients who own businesses make sure they’re not paying more in taxes than they need to.  One great tool we can use in this endeavor is a defined benefit retirement plan.  Whatever you want to call it, DB plan, defined benefits pension plan, etc., it can be a killer way to defer a huge portion of your income from taxation.

I realize you might cringe when you read the words “pension” or “defined benefit”.  The idea of promising employees a monthly check throughout their retirement may not foster warm and fuzzies.  But if you don’t have employees, or only have a few, a defined benefit plan can offer some pretty major tax advantages.

Read on to learn how you might take advantage of them.

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Top Strategies for Managing Incentive Stock Options

Top Strategies for Managing Incentive Stock Options

Incentive stock options, or ISOs, are a pretty common way for companies to compensate management and key employees.  Otherwise known as “statutory” or “qualified” options, ISOs are a way to give management a stake in the company’s performance without doling out a bunch of cash.

While they can have wonderful tax benefits, far too many people who own ISOs fail to exercise them wisely.  Some estimates even claim that up to 10% of in the money ISOs expire worthless every single year.  If you own incentive stock options but aren’t sure how to manage them, read on.  This post will cover a few of the top management strategies at your disposal.

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ERISA Section 404(c): Another Way for Plan Sponsors to Limit Legal Risk

ERISA Section 404(c): Another Way for Plan Sponsors to Limit Legal Risk

Sponsoring a qualified retirement plan is a pretty convenient way to defer taxes AND offer your employees a valuable benefit.  It comes with some hefty responsibilities, too.  Among other things, you’re obligated to act in the best interests of your participants, monitor expenses & performance, and make sure everyone’s getting the proper disclosures.

However, to make your life easier ERISA includes six nifty safe harbor provisions.  By following a few additional guidelines your plan can qualify for these safe harbors, which relieves you of certain fiduciary responsibilities.

We covered one of the six safe harbors a few weeks back: auto-rollovers.  Today we’ll cover another safe harbor: section 404(c).  This section has to do with who is responsible for the investment performance in your participants’ accounts.

If you’re responsible for a qualified plan and are curious about how you can limit risk, read on.  You’re in the right place.

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401(k) Auto Rollovers: A Convenient Safe Harbor for Small Business Retirement Plans

401(k) Auto Rollovers: A Convenient Safe Harbor for Small Business Retirement Plans

OK – with a new year upon us it’s time to clean up that rusty old 401(k) plan at your small business….right?  Let’s say that you work in or own a small business, and are responsible for operating the company’s 401(k) plan.  To put it lightly, it’s probably a massive nuisance.

401(k) plans can be a wonderful benefit to your employees AND a great opportunity for you to put more money away for retirement in a tax deferred account.  But as you may now, operating a plan can be a real bear.

I’ll be covering the finer points of operating small business retirement plans throughout the year.  Today’s post will focus on what to do with departed employees.  Employees will come and go to and from your business over time (hopefully not too often), and it’s not uncommon for them to leave money they’ve accumulated in your company’s qualified retirement plan.

 

ERISA & Fiduciary Responsibility

As you probably know, departed employees always have the opportunity to pull their money from your plan after they leave, either directly or via a trustee to trustee rollover.  But many employees neglect to do so.  Whether it’s because they don’t know how, don’t care, or are simply lazy, it’s very common for departed employees to “accumulate” in your 401(k) plan, long after leaving the company for greener pastures.

As you also know, as the sponsor of a qualified retirement plan you have certain fiduciary responsibilities when it comes to managing the plan on behalf of your participants.  It’s for this reason – fear of repercussion – that many sponsors feel stuck when it comes to managing assets of employees who long ago left the company.

Fortunately for you, ERISA was not written with the sole intention of making your life hell.  There are six safe harbors written into the law that free you from fiduciary responsibility if you follow a few step by step instructions.  And one of them conveniently covers departed employees.

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