401(k) plans have become the standard for companies to help their employees save for retirement; however, the rules for participating present challenges for the owners and other executives of businesses who usually meet the definition of a highly compensated employee (“HCE”). The 2022 contribution limits apply to all employees, including HCEs, and permit a participant to contribute up to $20,500, and if age 50 or older, $27,000. In reality, due to required compliance testing, many owners of professional service businesses are not permitted to save the full amount or are altogether excluded from participating.
As a result, physicians, attorneys, CPAs and other high-earning business owners are increasingly taking advantage of Split-Funded Cash Balance Plans as as a more efficient means of saving for retirement, not only maximizing their pre-tax contributions but creating a source of tax-free retirement income and death benefit.
At Cedar Point Financial Services LLC, our team collaborates with actuarial professionals to design and implement retirement solutions, including Split-Funded Cash Balance Plans.
The Problem
Each year, 401(k) plans undergo compulsory compliance tests to ensure there is no discrimination in favor of HCEs who earned $135,000 or more in 2022. Passing these compliance tests will ensure plan benefits and contributions fall within the IRS permitted ranges:
IRC §401(b) Minimum Coverage. Tests the population of HCEs versus the rest of the employees benefiting from the plan to ensure there is enough non-HCE participation.
Actual Deferral Percentage (“ADP”). Tests plan deferrals to ensure the HCEs may not exceed the ADP of the non-HCEs by more than two percentage points. In addition, the combined contributions of all HCEs may not be more than two times the percentage of non-HCE contributions.
Actual Contribution Percentage (“ACP”). Tests use a similar method as the ADP test except that it uses matching contributions or employee after-tax contributions.
Top Heavy. Tests the account balances of plans to ensure that HCEs do not own more than 60% of the value of the plan assets.
All these tests provide many chances for a 401(k) plan to fail or limit how much the business’s owner can contribute. When this happens and non-HCEs are not saving enough as a group, the amount HCEs are allowed to save is reduced or an employer may have to make “corrective distributions” and return some of the HCEs’ saving in the form of taxable compensation.
Worse yet, recordkeepers and plan administrators will usually conduct testing for the year in the first quarter, so a testing failure may not be known until the tax year has ended. Business owners are able to enhance the percentage of benefits for themselves and maximize pre-tax savings by adding a Split-Funded Cash Balance Plan on top of an existing 401(k) and/or profit-sharing plan better addressing their own retirement income needs.
Cedar Point Financial Services LLC specializes in assisting employers in educating, designing and implementing savings strategies for their top talent.
Business Owners Save with Split-Funded Cash Balance Plans
Business owners seeking to save $100,000 or more each year on a pre-tax basis are increasingly turning to split-funded cash balance plans to create a pool of future tax-free income. A Split-Funded Cash Balance Plan is a type of tax-deductible, qualified retirement plan that maximizes contributions while taking advantage of pension life insurance.
The plan’s name comes from the ‘split’ in using plan contributions to purchase both cash value pension life insurance and other investments. The ultimate goal of this pension life insurance strategy is to either have the participants life insurance trust purchase the policy to keep its income tax-free death benefit out of the participant’s estate or to have the participant purchase it him or herself to provide valuable tax-free retirement income. In all, participants enjoy these advantages:
- Larger tax-deductible contributions than other qualified plans.
- Ability to purchase pension life insurance with tax-deductible premiums.
- Protection of retirement assets from creditors.
- Tax-free retirement income.
Business owners want to save more and are working with Cedar Point Financial Services LLC to mitigate the impact of potential plan testing failures by participating in Split-Funded Cash Balance Plans.
How a Split-Funded Cash Balance Plan Works
Sheldon is a 53-year-old with a profitable law practice and an annual compensation of $1 million. He is currently able to annually fund his 401(k) and a profit-sharing plan with $61,000 to each. Sheldon wants to save more so he can meet his goal of retiring at age 62. Ideally, he wants a qualified plan that will allow him to make significant contributions toward his own retirement and provide tax deductions.
Sheldon establishes a Split-Funded Cash Balance Plan and makes annual tax-deductible contributions of $317,349 for the first five years and $262,334 for the next five years. During the initial five years, the plan purchases a pension life insurance for $131,000 a year in premium for 5 years. The initial death benefit is $2,145,000 and the beneficiary of the policy is the qualified plan.1 The remaining $186,349 of Sheldon’s annual plan contribution is invested in a diversified portfolio. Over the following five years, Sheldon will allocate his entire allocation of $262,334 into the plan’s diversified investment portfolio.
At retirement, Sheldon has several options. As is typical with any defined benefit plan, one of the options is for Sheldon to take either a single-life or joint-life annuity payment. The plan may also offer a lump-sum distribution which Sheldon may elect to roll over to an IRA to reinvest however he’d like.
Next, there are several options to consider regarding the life insurance policy which Sheldon (or his great or trust) can purchase away from the plan tax-free. If Sheldon wishes to supplement his retirement income by accessing the policy’s cash value tax favorable, once the policy is owned personally it could provide tax-free income via policy withdrawals and loans. Starting at age 63, this policy would provide Sheldon with $56,658 a year income through Sheldon’s 90th birthday.2 This tax-free amount would be in addition and complementary to the taxable funds he would draw from the investment portfolio.
On the other hand, if Sheldon wants to use the life insurance coverage for his estate planning, the policy could be purchased for its fair market value by his life insurance trust. This transfer usually takes advantage of an irrevocable trust where the policy will be situated outside of Sheldon’s estate and the death benefit will be income and estate tax-free and available to pay estate taxes and/or to provide for heirs.
Flexibility Provided by Split-Funded Cash Balance Plans
Split-Funded Cash Balance Plans are versatile. A plan design may consist of a “stand alone” Split Funded Cash Balance Plan or a combination of 401(k), profit-sharing, and the Split Funded Cash Balance plan overlay. Every plan is customized based on many factors and the exact contribution amounts for each participant are subject to an actuary’s testing. Today’s plan designs are quite flexible, but and, of course, can be reevaluated if there are significant business changes in the future and the plan poses financial hardship to the business.
There are a number of rules and formulas that need to be followed to successfully implement a Split-Funded Cash Balance Plan. Creative design and proper plan documentation are critical when taking advantage of including pension life insurance. It is critical to select a seasoned Third-Party Administrator (TPA) who is familiar with pension life insurance as a component of qualified plans, ensuring that documentation, implementation and administration are handled correctly.
Also, the IRS has established guidelines which dictate how much pension life insurance can be purchased in a qualified plan, ensuring that the plan does not stray from its primary purpose of providing retirement income.
The Key to a Comfortable Retirement
For many accomplished professionals and business owners, meeting future income requirements by relying on a 401(k) or profit-sharing plans is challenging. Discrimination testing can significantly reduce the ability of these high earners to save cost effectively. Establishing a customized Split-Funded Cash Balance Plan may be a solution that permits large contributions, provides tax-diversified retirement income, andenables the purchase of pension life insurance with tax-deductible premiums. Cedar Point Financial Services LLC and its actuarial partners can provide business owners professional assistance in designing and implementing creative and valuable Split-Funded Cash Balance Plans.