006 | Business Owner Retirement Plans: A Deep Dive into Level 2 Tax Planning with Bruce Gendein

Have you ever wondered how a Cash Balance Plan can help reduce your tax burden while supercharging your retirement savings?

In this episode of the Vital Strategies podcast, we welcome Bruce Gendein, an expert in maximizing retirement plans for business owners. Bruce’s decades of experience in level 2 tax planning shine through as he explores the flexibility of Cash Balance Plans.

In our conversation, Bruce provides innovative solutions for business owners, aiming to both minimize tax liabilities and build wealth efficiently. This episode is a valuable resource for business owners and those interested in tax-efficient financial planning, offering insights that could potentially save hundreds of thousands of dollars in taxes.

Key Takeaways:

  • Utilizing a cash balance plan
  • Running calculations to demonstrate the workings of cash balance plans
  • Asset protection
  • Reaching the maximum benefits within a plan


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Sponsored by Vital Wealth

Music by Cephas

Produced by BrightBell Creative

Research and copywriting by Victoria O’Brien

Episode 006 | Business Owner Retirement Plans: A Deep Dive into Level 2 Tax Planning with Bruce Gendein

Patrick Lonergan: Welcome back to the Vital Strategies podcast. I’m your host, Patrick Lonergan, and today we’re speaking with an expert, Bruce Gendein, who knows how to maximize the benefit of retirement plans for business owners. Make sure you listen to the end to hear how business owners can put hundreds of thousands of dollars in a retirement plan to minimize their tax bill.
When it comes to level two tax planning, where the IRS gives us clear guidance and we have to make a financial investment, Bruce has a wealth of experience that spans decades. Bruce is dedicated to navigating cash balance, retirement, and pension plans. From dissecting the nuances of different planning types to devising innovative solutions, Bruce offers a unique perspective on these opportunities.
Today we’re taking a deep dive into the flexibility that cash balance plans can offer. In this episode, Bruce breaks down the various ways in which these plans can be tailored to suit business owners looking for an efficient way to maximize tax savings while still being able to build wealth. So, whether you’re a business owner seeking to make the most out of your retirement plan or just eager to learn more about tax efficient financial planning, this episode will help you transform your financial outlook.
Let’s get started.
Bruce, I really appreciate you joining us today. I’m excited to get into this discussion about cash balance plans, defined contribution plans. But, before we get into all of that, can you give us a little bit of background on retirement plans, design, implementation?
Bruce Gendein: Yeah Pat, thanks for including me. You know, I’ve been doing this since just after ERISA started. I started in 1975 designing and implementing pension plans at first as a financial advisor and then as a full-service actuarial consulting and third-party administration firm, helping other advisors put plans in for their clients.
You know, during that time, I’ve helped adopt thousands. Of qualified plans and the situation has changed over time. As you know, plans have gotten very, very exciting lately because of all the new limits and flexibility that’s built into them. And we’ve been very fortunate over the years. During that time, I’ve had wonderful relationships with investment sponsors and insurance companies who have many times asked me or my firm to help them design products that would fit the qualified plan arena and to help them market those plans through their financial advisor networks.
Well, in 2018, I was fortunate enough to find a firm that wanted to buy my third-party administration and marketing firm and after a suitable period of transition, I started working with Scott McHenry at McHenry Advisors.
We had collaborated for probably 4 or 5 years prior to that and so we’ve had a wonderful opportunity, uh, because what it does is it provides tremendous continuity for the financial advisor and their clients. We’re a full-service third-party administration and consulting actuarial firm. We have nine actuaries on staff we administer somewhere north of 2,000 pension plans, and we have clients in all 50 states.
Patrick: So, Bruce, one of the things, you’ve helped us implement a number of cash balance plans for our clients. Can you give us the 30,000 foot overview of what a cash balance plan is?
Bruce: Sure, sure, a cash balance plan is a pension plan, and it’s sort of a brother of a defined benefit plan. As a matter of fact, a cash balance plan comes over, comes under all the same limitations and restrictions that a defined benefit plan would, but it’s a hybrid. So, it’s expressed more like a defined contribution plan. There’s a pay credit and an interest credit. And so, we get away from the accrued benefit, and we’re talking about the account value, okay?
While there aren’t separate accounts in these plans, what they have is they have a cash balance that’s due to the employee. And what happens is they are all employer functioned, you know, and contributed. There are no employee contributions to these plans. And they’re very unique in that they are for specifically very successful, closely held business owners and professionals.
It’s for a client who makes a half a million dollars or more and would like to contribute $100k, $200k, $300k, or maybe even more annually to their retirement plan.
Patrick: So, you touched on this a little bit. What is the ideal client profile of somebody that would be looking to implement a cash balance plan?
Bruce: The ideal client profile is someone who, like I say, they’re a successful business owner or professional. They have half a million dollars a year of income and don’t want to pay taxes on all of it. They would like to contribute and deduct $100k, $200k, $300k or more. They have few, if any, employees, and the employees they have are often younger, at least half of them are younger than the owner, and they make a lot less money. So, that’s the very basic.
On a better term, and you know since we’ve done a number of plans with your firm, that… Don’t meet that model. And the reality is, is cash balance plans in today’s world are very flexible and they may work very well because I may have had a 401k profit sharing plan for a number of years that wasn’t top heavy and would allow me to design a cash balance plan as a top hat to it that I could give the majority of the benefit to the owners for a number of years.
Sometimes you have a firm with very, very high turnover. And so, while they might have a number of employees, they don’t stay long enough to become, you know, this is often the case with some restaurants and other industries like that.
But I will depart a little bit and tell you that the ideal client, like in most planning situations, the ideal client is one who takes the financial advisor’s advice.
Patrick: That’s great. I like that because I think you’re right. We’ve had clients that have had 100 employees that we’ve been able to put a cash balance plan in place and it worked really well. But we’ve also seen examples where we can really dial up the benefit for the owner when there’s zero or maybe a few employees that are participating in the plan.
Bruce: One of the things that that’s kind of interesting, and I’ve said this for many years, is that 401k profit sharing plans are wonderful tools, and they are a great employee benefit. You ask, well, who’s the ideal client? The cash balance plan is really designed to be an owner benefit plan in the small, closely held business market, and we’re trying to get, you know, we know from experience that if we can get the owner 80%, 85% or more percent of the contribution cost of the plan. He’s almost, or she’s almost always interested in pursuing it and implementing the plan.
Patrick: Yeah. Cause one thing we look at is like, if we have a choice of giving, we’ll call it 10-20% of the benefit to the employees or giving 37% or more to the IRS, I think most of the business owners look at it and go, I would rather give a benefit to my employees and then be able to retain the rest of those dollars and get enjoyments inside of the plan.
Bruce: So, you know, you raised an interesting point, Patrick, because there’s also the fact that when I make contributions to the employee on the employee’s behalf, what happens is some of them don’t stay long enough to become fully vested. And if they leave and they’re only partially vested, they forfeit the unvested part. Which then reduces future years contributions, which in fact accrues to the owner’s benefits. So, if I say we initially started at 85% going to the owner, I know that forfeitures along the way may raise his overall total to 90% or maybe even more.
Patrick: So, we’ve talked a little bit about where a cash balance plan works. Are there some examples of where a cash balance plan doesn’t work nearly as well? Is there a particular business or industry that we can look to?
Bruce: Yeah, I don’t think you can look to a business or an industry except when I, when I say that, you know, if you said, well, I have a client and he has five companies and three of them are manufacturing and they each have 300 employees.
Okay. We have a controlled group, we have 400 employees to deal with, and only two owners, it’s hard to overcome that. It just, you know, so size is sometimes an issue, not necessarily the industry. Although there are some industries that are a little unique, like automobile dealerships are a little unique, because one of the things most people don’t know is their highest paid employees turnover. It’s their sales force. And so, and you aren’t going to Incentivize them to stay with a retirement plan. So, you tend to have a lot of other people in the plan And my experience is they have not focused on employee benefits over time So sometimes they’re not as good although we’ve done a number of plans for auto dealerships Okay, so it’s there are a lot of different twist to it.
You can use any type of industry. The critical thing is that they’re a successful business, that they have a desire to put money away and save taxes, use it as a tax control tool, and it doesn’t matter how they’re organized. They could be a sole proprietor, they could be Partnership, C Corp and S Corp and LLC taxed in any way they want just a slight difference in accounting.
That’s what makes them so flexible.
Patrick: So, would it be fair to say, just from the things we’ve talked about so far. And I’m a business that has a large number, let’s say, 50 of long tenured employees without a lot of turnover. That are highly compensated, that might not be a great place to try to put a cash balance plan with that. Would that be fair?
Bruce: Yeah, you know, I’m going to say yes, but yes, is the short answer, but is the more interesting part. And the but comes in the form of depending what you mean by highly compensated. There’s a threshold for highly compensated employees in the law.
So, for example, it’s always a look back year for 2023. The look back is $150,000 in 2022. And it says that if somebody made $150,000 in 2022, I may be able to exclude them from participation in the plan. And it may give me a great profile. So, even if I had a lot of high paid tenured employees, the plan might still work. What I guess I’m going to say to you, Pat, is the very best way, rather than to try and out people out, disqualify them, if you will. It’s always better to complete a plan design study, get a complete census, maybe even a three year history of compensation, and let us see if we can come up with a strategy that would make something work effectively for that business owner.
Patrick: I love it. And that I would agree with that 100%. We brought the business owner that had 100 employees thinking it might be hard to get it put together.
And you guys did a fantastic job designing it in a way that worked really well for everybody.
Bruce: Yeah. You know, one of the things about the feasibility study or plan design study. Is that we work with you as financial advisor and absorb the cost of it. So the client’s only real cost is the collection of the data and giving a full disclosure about what they’re doing and what they’d like to have done.
And so, if you’ll let me kind of divert for a minute about the way I’ve opened many, many, many cases. Is I’m sitting with somebody and, and I, you know, the conversation often comes around. What do you do? What do you do? And he says, well, you know, we’re in this business or that and says, sounds interesting.
Tell me more. Well, we’re having just record years and so on. Well, it sounds like you might be paying more income taxes than you’d really like to. Oh, God, we’re getting killed. You know, what I say is, you know, there are a lot of new tax control techniques that are available to business owners like you and I don’t want to be presumptive and say anything might work for you, but let me make a suggestion. If you’ll share some information with me about what you’re doing currently and what the end game you’re looking for, I’ll absorb the cost of doing a feasibility study. And I’ll come back to you in a couple of weeks. I’d like to sit down and go over what the results are and determine if any of the ideas that we have would be attractive to you and we can involve your accountant and other financial advisors.
And the only thing that I’m going to ask. Is if any of these ideas look attractive and you decide you want to implement them, you’ll at least give vital wealth first consideration at the implementation, who would I see the data and, you know, I’ve opened thousands of cases that way and it saves the situation where you’re being promissory.
Oh, this is great. No, you’ll love it because I don’t know that until we know what the data looks like. But once the data looks like we. Thank you. Can come back in and we can be very specific about what we can do for that business owner.
Patrick: That’s great. And I love that because it’s an easy way to introduce the concept without any commitment from the, the business owner. They’re like, please look at opportunities to save me tax without it costing me any money. So, all right, Bruce. So, getting into some of the nuts and bolts, if we can, if I, if we have an example of a business owner, who’s 50 years old, Let’s say they take a salary of $325,000 from the business, and they have a total net income of $1.2 million total. Uh, so their salary and their distribution is $1.2. How much money could they put into a cash balance plan?
Bruce: Well, first of all, you probably want to know that there are two factors that impact how much money can go into the plan. The two factors are age and compensation. W2 salary, anything that is earned income subject to payroll taxes or self-employment tax can be the basis for a retirement plan contribution.
So, if they’re 50 and they’ve got plenty of money, I can tell you that he can probably put close to a quarter of a million dollars, let’s say $270k even, into the cash balance plan on a level basis over time. In addition, at that salary, he could also have a 401k profit sharing that he could probably contribute another $50k into.
So, he could get very close to three and a quarter contribution and three and a quarter salary. Now that leaves him at $650k, which is about half of what their net income is. But that leaves a little bit of room for other employees.
Patrick: Sure. No, that’s, that’s fantastic. Because when we look at things like a traditional 401k plan, the limits are significantly lower than that. And I think a lot of times our business owners are looking for opportunities to find. Ways to get more dollars into a tax deferred strategy that doesn’t step outside the bounds of IRS rules. And this is clearly one of those opportunities where they can get significant dollars into a plan that is very black and white with the IRS.
Bruce: In this particular case, let’s just do a comparison. I mean, you know, if he’s putting away $300,000 into the cash balance, 401k profit sharing combination of plans. That would compare to about $67,500 maximum into the 401k profit sharing alone. So, you’re looking at a multiple of five, lots of difference there.
Patrick: Absolutely. Absolutely. And even if we find a lot of our, our clients are saving all of that money anyway, you know, they’re, they’re putting it into a brokerage. And so when we, we think about that, it’s, and if they’re in a high tax state, like California and New York, they’re paying close to 50% of their, those earned dollars to tax anyway.
So if I have a choice of putting $250,000 into a cash balance plan, or $125,000 into my brokerage account, I think I’m going to default to the 250k into the cash balance.
And let me take it to somewhere that you haven’t asked about, but you know, let’s say I put 250k in and I save 50% tax. And somebody can come back to me right away and say, well, yeah, but it’s just tax deferred. And when you take it out, you’ll pay taxes. And I say, well, that’s true, but let me tell you how it works. When I put the 250k in it’s out of my top tax bracket, out of that 37% federal tax bracket, maybe 35, but it’s out of my top tax bracket. If I took the money out the next year and I, when I take it into income, I only take it into income from the bottom up.
So, I’ve got the standard deduction of 25. I’ve got the 10% bracket of 20. I’ve got the 12% bracket of 58. I’ve got the, well, if I took the same 250k out the next year, I would probably only average about 15%, 17% tax. So, I immediately had a 20% tax arbitrage from what I put it in at and how I got it out.
And a lot of times that goes without mention, and I think that clients ought to be aware of that, that they have this sort of arbitrage just doing it.
Patrick: Absolutely. And one of the things that we, we work awfully hard on is, you know, the tax efficiency now, and then the tax efficiency on withdrawal later and without getting too deep into the weeds, we’ve talked a fair amount about life insurance and cash balance plans and tax free income and, and we love a strategy that has, I’ll say, 50% tax free income and 50% taxable income, because we can have the same income we were living on, but only half the taxable income.
And so, if we can defer it at 37% plus and draw it out, you know, like you were saying in those lower tax brackets, it’s, it’s absolutely a winning strategy.
Bruce: I may be able to draw it out at zero. And here’s why I say that you raised an interesting point is, you know, we call our approach, the modern qualified plan, because, you know, over the years, every plan that I’ve ever established initially was always done as a tax motivated plan.
I need the tax deduction now, and I can tell you along the way, there are going to become two other watershed events that will change the client’s attitude.
The first one is when they put the second comma in their account value, that million dollars of investable assets are very important.
The second watershed event is when the one handle turns to two or a three handle.
This 3 million is still a lot of investable assets today. So, you know, the idea that I put the money in and tax deducted, it grows tax deferred. It’s all asset protected from creditors. By the way, I’ll share something with you. People always ask me, what do you mean by that? Well, the company has put the money in the plan. So, it’s no longer the money belonging to the company. So the company’s creditors can’t get at it. And the participant hasn’t received the money yet, so the participant’s creditors can’t get at it. So it’s doubly asset protected while it’s in the plan and within certain rules and other things. It’s not even an admissible asset in federal bankruptcy.
So, that’s, that’s pretty asset protected. So, you get this tremendous. Opportunity for this to happen. Well, not only that, but when we were talking about of tax efficiency on the back end, you’re right. We look for ways that when we establish either a defined contribution or a defined benefit plan in the defined contribution world, everybody’s familiar with Roth and we look for opportunities to do Roth for the right client so that the benefit at least partially will come out tax free on the other end.
So, we do an analysis of that and as you pointed out we use a Investment grade life insurance contract to be a component of the funding of the plan So when we finish funding the life insurance and remove it from the plan We now have a source of tax free income to go with The taxable income, the plan provides.
So, we maximize that after tax value of what the plan provides over the life cycle of the plan.
Patrick: I love that. And I love the, the efficiency and the economics of how the life insurance works and all of that. I think it might be a little outside of our scope today, but, we can get into that when we have, I’ll say one on one conversations with clients, but, it’s amazing how we can, there’s just tremendous economics that work all the way through that, that strategy.
Yeah, it’s, you know, the thing that makes plans great is they’re all black letter law. In other words, it comes right out of the code, how they work. It’s not, oh, I have an opinion from a large law firm that under most circumstances, this might work. Okay. It’s just, it’s so much simpler than that.
Patrick: Absolutely. We talked through three, actually four levels of tax planning. Level 1 is good bookkeeping in the IRS gives us guidance. Level 2 is IRS gives us guidance, but it takes investment. Okay. Like cash balance plan 401k. The great thing about those plans is there’s not, like you said, there’s not a problem with the, the DOJ or the IRS knocking on my door saying, Hey, we’ve got some tax fraud taking place here.
Uh, level 3 is the IRS doesn’t like these plans, you know, and those could be things like captive insurance or, you know, a number of those strategies and level 4 is what we like to refer to as tax fraud, because there’s people out there selling these strategies, like they’re legitimate and they’re.
They’re not, and we like to be able to put those in a category. So, we think cash balance plan, the number of dollars we can get in there, how low cost it is to really set one up. And then the fact that it just fits clearly inside the letter of the law is just an absolute winning combination for us.
Bruce: Well, you know, you, you hit the nail on the head.
Why it’s become my life’s work is because, you know, I can’t tell you how many people have. Become multi-millionaires, liquid assets, as a result of doing that kind of planning and, you know, it’s just real, real simple. If you want a happy client, help them make a lot of money.
Patrick: So much truth in that.
Bruce: Yes, you know, there’s, there’s an old saying, Pat, you might like, and it comes into pension plans and, you know, the question always is.
Is the juice worth the squeeze and with pension plans, it virtually is always worth the squeeze. The squeeze being there are fees associated. It’s a little complex. It’s, there are things that, you know, you have to put up with, but the opportunity is so great that those become very minor.
Patrick: Absolutely. I agree. And we have this conversation frequently with our clients. People will say to us, you know, they’re, they’re making very healthy incomes, their net worth has grown. And they’re like, man, this is my financial life has gotten awfully complex. And there’s a lot of truth to that. You know, you’ve got tax, legal investments, insurance, all these different factors coming into play.
And there’s, you know, if you want a very simple financial life. Have $10 in the bank and go just get a job and earn a little more money. Like that’s very simple, but at the end of the day, you know, the complexity comes as your net worth grows and your income grows and your tax problem grows. And, even those things you mentioned, yes, they bring a level of complexity, but it’s not a tremendous burden once it’s set up and the client understands.
That’s where I think our team and your team work together to make it sort of white glove for the client. They don’t have to worry about much of anything other than the funding.
Bruce: I’ve always said you can make big mistakes and you can make small mistakes. And to me, the big mistake is always paying the tax before you need to.
Patrick: Absolutely. I don’t like giving the IRS any more money than I need to in any particular time.
Bruce: Yeah, I mean, you know, you can give them the right amount. Or, you know, postpone it. I mean, it’s, you know, the longer you get to use it, the better off you are.
Patrick: Absolutely.
Bruce: You know, one of the things that we always talk about is the fact that when we get a planned design study in, I’m not very successful at changing age.
Okay, but we may make some recommendations about how they take money out of the plan out of the company rather taking it out as salary rather than as an S Corp dividend. Let’s say, and increasing their salary. They have this other opportunity when they take it out as an S Corp dividend. They get to pay the tax when take it out as salary they may have a commensurate plan contribution. That makes it a lot more attractive.
Patrick: Absolutely. And. Yeah. And that’s it. That’s an interesting point, because we’ve seen some clients that work pretty hard to keep their wage out of the business low, which I can understand because there’s some payroll tax associated with that.
But when we have an option of paying a little more payroll tax and getting a significantly larger income tax deduction, I would rather pay a little bit of payroll tax. And then save the income tax side.
Bruce: You’ve hit the nail on the head. We’ve been asked to do studies over the years. Well, if I raise my salary this much, I have to pay more payroll tax. And we, what we do is we say, well, if you have to pay X dollars, more payroll tax, the contribution to the plan is at least 10 times that amount.
Patrick: That’s fantastic. Makes it very clear. Yeah. So, we talked a little bit about contributions into the plan. And in our example, we talked about our 50-year-old making $325,000 and you made a comment about them having, they can make a level contribution of $270,000.
Can we talk a little bit about the flexibility inside of the plan? Like, can they contribute more than that? Can they contribute less? Let’s say businesses going well, but they’re making some additional investments in the business and maybe don’t have quite as much liquidity to put into the plan.
Can you talk a little bit about that?
Bruce: Of course, of course. That’s a great question. These plans are extremely flexible, and this has been the case for the last probably dozen or so years in the Pension Protection Act, the government came to the conclusion that they ate underfunded plans. Because they know that they’re likely to be able to end up picking them up under the PBGC takeover when the company files bankruptcy or turns the plan over, and it’s way underfunded and so on. And I don’t know, with 31 trillion dollars of debt, they probably don’t want any more contingent liabilities.
So, they came up with a funding method that is termed the cushion amount funding method and what it does is it’s and it’s the only approved funding method today for defined benefit or cash balance plans and what it says is in when years are good, you’ll be able to put a lot more money in and deduct it and that will be a pre contribution of future money so that you will have excess assets in the plan so that when a year comes along that isn’t quite as good You’ll be able to put a lot less and maybe nothing in the plan. And that’s the funding method itself. By the way, that says that there’s going to be a range from top to bottom, maximum to minimum.
Normally, that range is about tenfold. So, if the top end of the range is $300,000, the bottom end of the range will be $30,000 or $35,000. The recommended or level contribution, as we mentioned before, is going to be the targeted amount that will get you there over ten years.
Let me give you an example. At age 62, the maximum benefit under today’s law is $265,000 of annual benefit coming out of the plan. There is a conversion rate that says that has a lump sum equivalent of $3.4 million approximately. Well, if I’m 10 years from retirement and I’m assuming a five year level funding or a five percent rate of return over a 10 year level funding, I need to put in close to $300,000 a year.
Well, my top end may be $450,000. And my bottom end may be $45k or $50k. So you would say, over time, I want to contribute about 300, but I’ve got this flexible range. In good years, I can put in more. In bad years, I’ll put in a lot less.
Patrick: Got it. Great.
Bruce: That’s why they work so well. That’s why they’ve been taken CPA community as a wonderful tax control tool, because they are flexible.
Patrick: Absolutely. And we agree with that. We try to get a little bit ahead of the funding and get more dollars in early. So, if we need to fund less later, we’ve got the flexibility.
Bruce: And that’s a great strategy, Pat. And the reason it’s so great is because all of the limits are indexed with CPI, the wage part of CPI.
And so, like we know last year, the Social Security benefit was increased by 8.7% or these numbers so that the maximum salary that you could count for calculation went from $305k to $330k. The maximum benefit went from $245k a year to $265k a year. Doesn’t sound like very much. But it took you from about a 3 million lump sum to a $3.4 million lump sum. And I bring that up because, you know, people say, well, what if I over earn, or what happens if I want to work past retirement age?
Well, I’ve got that additional amount that I can fund. Yep. You know, so there’s a lot of different flexibility in there.
Patrick: Yeah, that’s fantastic. Thanks. So. If we go back to the example of the business owner we were discussing earlier, that’s 50 years old and the level funding it to $270k or so, do you have a rough idea what the upper end of that funding would be?
Bruce: Yeah, it’s probably about $350k. It’ll depend on his past or how much, how long he’s worked for the company and his history and so on. But I’m going to guess under normal circumstances, there may be $100k or $150,000 more that he could contribute in the given year.
Patrick: Yeah, that’s a fantastic opportunity if you need to move some money into the non-taxable column or the tax deferred column.
Bruce: Let me tell you about a case study that highlights the flexibility on funding. In 2022, we did a plan for a political consultant. Now people say, what’s odd about political? In even years, he makes a fortune. In odd years, he makes nothing. His funding from maximum zero, maximum zero, maximum zero. And we just had it planned out to do just that. So, when I say they’re flexible, that’s pretty flexible.
Patrick: Absolutely. Yep. I love that. So, we’ve touched a little on tax efficiency on both the front end, like let’s get the deduction and then talk a little bit about some opportunities on the back end. Can you. Dig into a little bit of strategy that we can use to create some tax-free income on the withdrawal phrase of the plan.
Bruce: Sure. You know, if we use a life insurance product as a component of funding, the premium is part of the deductible contribution because the cash value is part, are part of the assets that provide benefits. So, we rock along and we accelerate the funding of that life insurance contract so that we get it all paid for within, let’s say, five years. That means at that point, I’ve paid a lifetime of premiums in five years. I have also thus paid a huge amount of prepaid expense. So, while it’s in the plan, people always ask me, well, I’ve got a tax efficient product inside a tax efficient entity. I said, well, yeah, but I got a tax deduction for doing it.
So, you want to get it out? And he says, Oh yeah, I’d like to get it out. Well, there are specific exemptions that the department of labor has given us. Um, number. Prohibited Transaction Exemption 92-6 that says you can offer this product for this policy to the participant for its fair market value.
And the IRS came out and said, look, we don’t want any cheating. We’re going to give you a revenue procedure that will determine the fair market value and it’s revenue procedure 2005-25. It says here’s how you calculate. And so, what we find is that when you go to buy it out, that fair market value is about 30% discount from the premiums paid. Well, I deducted the premiums anyway, so I probably had at least a 30% or 40% discount on that.
So, I got to deduct the premium, which is very unusual for life insurance. I now get to buy it from the plan. At a discount and my distributions, since I can access the cash value, the distributions are tax free, whether they’re accessing the cash value or the death benefit. So, I just call it 3D. You deduct it, you discount it, and your distributions are tax free, and that’s what gives a lot of the efficiency.
Our experience is that the insurance component will add maybe 10% to the funding cost of the plan over 10 years. And the life insurance will provide a tax-free benefit equal to approximately the after tax value of the rest of the fund.
Patrick: That’s fantastic.
Bruce: So, from an after tax point of view, it almost doubles the efficiency of the plan.
Patrick: So, if it’s okay, I’m going to put just a few numbers to what you just mentioned. And so if I, just to keep it simple, if I fund $100,000. Into the life insurance plan and deduct that $100,000 over, uh, let’s say a five year period, then I get to buy it out at fair market value, which sounds like it’s about 70%.
And so, I get to buy it out at 70% of the $100,000 I paid in. So, I take this asset out. It cost me $70,000 and oftentimes are you seeing cash values at a hundred or greater for that, that $70,000.
Bruce: Eventually you will see the math back, but let’s say that we paid $100,000 for five years.
So it’s $500,000. It is an asset of the plan. If I pull $500,000 cash value policy out of the plan, I’ve created a hole and so if you create a hole, it looks like it’s a planned distribution. So, you owe taxes on it. But what that prohibited transaction exemption 92-6 does it says you could take some non-qualified personal money and put it in to fill up the hole you just created now there is no taxation
Well, the revenue procedure says it’s probably worth about $350k. We’ll put $350k in the hole that’s how the plan was carrying it. I now own that policy. Well, we know eventually that policy will become worth more than that because it’s growing internally tax deferred. And eventually I can access either the death benefit or the cash value on a tax-free basis.
And that’s where I get this enormous tax leverage to make this all work well.
Patrick: That’s fantastic.
Now, Bruce, we’ve talked a little bit about a Roth component of a cash balance plan.
Bruce: A defined contribution.
Patrick: Yep, defined contribution plan. Is that something, forgive me if I’ve got this incorrect, a super Roth?
Something along those lines? Yeah. Is that something you want to dive into and just talk a little bit more about?
Bruce: It’s basically the concept of being a backdoor. Roth is the term that they use in the code. We call it the Super Roth and it just says that. In a defined contribution plan, if I haven’t used up all of the capacity in it for one reason or another, I didn’t do a deferral, I didn’t do as much profit sharing as I could. I could put that money in on an after-tax basis and it will be in there because as soon as it hits the account, it’s converted to Super Roth. And so now I have what’s called a backdoor Roth and effectively have gotten around the limitations on what an individual can do in a Roth IRA.
Patrick: That’s fantastic.
Bruce: Yeah.
Patrick: This next question is outside the scope. It’s something I’ve been just thinking about in general though. And I’ve thought about, okay, we use the life insurance inside of the plan. We take the life insurance out. And then we use the life insurance to do a Roth conversion on. All or part of the cash balance plan after we roll it over into an IRA, I don’t know. It just seems like there could be lots of efficiencies there.
Bruce: Let’s say I transfer the life insurance to the profit-sharing plan. I have a defined benefit and a defined contribution, and I transfer when it’s funded. I transfer the funded policy from the pension plan into the profit-sharing plan and there it sits and now I buy it out of there.
Now I have fresh money there and I have a balance of all the money in the profit-sharing plan. Well, depending on how much money I paid to get that policy out, I now have liquidity to convert the balance of those profit-sharing assets to Roth. If I have a sufficient number of years to let them cook and make sense, that could be a very powerful way to accomplish that.
And we do that regularly under a strategy we call Retirement Tax Minimization Strategy, RTMS. And the idea is if I have a big policy in the profit-sharing plan. I soak up some of the assets. I buy it out and I convert the balance of the assets to Roth. And now I have two pots of tax-free income coming to me.
So, it’s a great strategy.
Patrick: Great. Thank you.
All right. So, moving on to a question I have, and I think our listeners may have, is what’s the downside of implementing a cash balance plan?
Bruce: Well, you know, there is a downside. There’s a downside if you look for it anywhere. The biggest risk, of course, is that you had a terrible business reversal.
You know, I always think of 2008, you know, a lot of companies didn’t make the turn and so they can’t fund, they can’t do a lot of things and they’ve got to terminate the plan and they’re under pressure anyway, they lost their biggest customer, you know, the funding flexibility is great if it’s a year, maybe two years.
But if it’s longer than let’s say two years, we have to have another strategy and there are three of them. It’s going to be three or four. I may do what’s called put a pause on it. I freeze benefits for two or three years and I come up with a zero contribution. I let kind of, I put a pause on the timeframe. And now when we’re done with that, if business is back up, we start the benefits back up.
Number two, I can amend the plan. I said, well, we’ve been funding for maximum benefits all this time. Okay, we’re going to fund for 50% from here on out. We’ll protect what’s there already, but then we’ll amend down or we’ll change the actuarial assumptions. Instead of assuming 5%, we’ll assume 6.5% a lot less money to get there in terms of contributions.
And ultimately there’s, I can exit the plan. I can terminate the plan. If you want to know, I’m big on acronyms because I have a short memory, so I use the term RAM, R-A-M, I can revoke the plan, I can terminate it, I can amend the plan, I can change the benefit, I can change, and I can modify it, I can change the actuarial assumptions, I can do all kinds of other things, so in addition to the severe funding flexibility that’s offered by the funding method, I have these other three or four choices that I can use, and I can tell you that in the four decades I’ve been doing plans, I’ve never found a situation where I haven’t met, been able to meet what the client needed.
Patrick: And I like to just point this out as well, with almost any tax strategy where we’re investing dollars, there’s going to be some strings attached to that. Right. Like we can’t put the money in and then use it like a bank account. If somebody tells you they can, that’s probably in that tax fraud bucket is out there.
So, it’s a level four strategy that’s going to get you into lots of trouble. So, I think that’s, that’s clearly the, the thing that we’re looking at. Because we work really hard to help our clients manage liquidity. And so, we would like to make sure that we’ve got enough cash. For any unforeseen to run operations, and then if we’ve checked that box, then we’re happy to fund the cash balance plan, moving forward because it, it seems like it, uh, like we’ve discussed today, a fantastic opportunity to defer some tax.
Bruce: But that’s my political consultants, you know, example is, is if you can accommodate that, we can probably accommodate. Cashflow issues or, you know, because clients change their mind. You know, I always hate to see them change their mind because they want to take a big fancy cruise instead of funding the plan.
Okay. But, you know, that’s a different issue. And it’s 1 of the reasons people say, well, what’s the minimum contribution? Well, I said, well, you could put $67,000 in a 401k Brock return, which are in $67,500. So, you know, a hundred sounds like kind of a minimum number that you would want to consider. And that makes it big enough that small, personal cash needs, new drapes, a roof on the house, doesn’t alter your financial plan dramatically.
You know, if you’re putting away $40,000, those things tend to become very major issues.
Patrick: Yeah, no, that’s, that’s so true. And that’s, that’s one of the things that… We try to do a, we get into cashflow planning with our clients and we look forward at all of the both personal and business expenses coming up.
So, we like to put the cruise on the cashflow calendar and go, all right, that’s coming up in November. Let’s just make sure we’ve got proper liquidity to fund the cash balance plan, all of those other pieces and make sure that we’re not running ourselves into troublesome.
Bruce: And by the way, that’s why we like dealing with light of love because you guys do Excellent planning and it’s not there are no mysteries there, you know I tell people when I was little, I loved surprises Because my mom handled it and it usually involved a red bicycle at this stage there are no good surprises. So you guys do a great job of that and we Just really enjoy the opportunity to work together.
Patrick: Fantastic. Thank you. So, we’ve talked a lot about cash balance plans. Is this something a business owner can go do on their own?
Bruce: Uh, not likely. I mean, you know, it’s kind of like, you don’t want to do your own brain surgery.
The savings aren’t big enough. To justify it. Let me give you an example. First of all, you need a plan document. Could you go and get a plan document? Yeah, you probably could. And, but we charge $1,545 to set up a plan. Gosh, I can’t imagine, you know, what you would do that you wouldn’t make more doing in your business than doing trying to do our job.
And the same thing is filing a 5500. It’s, it’s not that hard, it’s just that why would you take the time to learn how to do that when we’ll do it for you for $2,400 and $50 a participant and it’s all deductible. When you do it, there’s no deduction.
Patrick: Yeah. And, and we had a client that came to us and they had actually somehow put their own cash balance plan in place. And they were like, we are so done trying to do all of this. Please help us. And the software professional, and we called you and said, Bruce, can you guys help us take a look at this plan? Make it more efficient. And the cool thing was, we were able to get more dollars into the plan. It was run more efficiently, effectively for the client. Like it was a win the whole way around as far as they were concerned. And, uh, I think it can be done, but it, it’s not worth the, the, the hassle to, to try to administer it yourself. So, you know.
Bruce: I’m not sure that building my own house will save me any money. And I can tell you that when I have casts on both arms and both legs when falling off the ladder, I can assure you that it will look less appealing.
Patrick: Yes, I’m handy at a few things, but I’ve learned that lesson enough times in my life where I try to do it myself and the frustration and the time and energy it takes me and the. The new tools I had to buy, I’ve just, I’ve resorted to, I’m just calling the professional to handle this moving forward.
Bruce: And you know, I think that I think you hit the nail on the head is that, it will frustrate a client trying to be you know in depth in pension planning And you know, they’re going to miss a lot of opportunities And we have nine actuaries on staff and there are still some times where we can find better ways to do things then we did it last year.
Patrick: Great. This has been wonderful talking about how to design a plan and fund a plan. Now, I know you’ve seen a number of plans implemented and taken all the way to the point where the owner retires. Can you talk a little bit about what a successful plan looks like for a business owner when they hit retirement?
Bruce: Yeah, let me stop in the middle of that. And I’ll tell you a story out of my personal history. And it was a client who we had funded. He had been in the oil field business selling oil field equipment and he was making a lot of money and we funded his plan. So he had a couple of million dollars. This is a long time, many years ago, and then he decided he was going to have an oil field supply business.
So, we built it up at 500 employees, had two machine shops, he had eight trucks, he had tubular goods everywhere. For those who are in Texas and Oklahoma know all about that stuff. And of course, the bloom came off the lily back in the late 80s. And he called me, he said, Bruce, could you come over? I’d like to buy your lunch.
We’re the only two people on the whole square block in town that he owned, where all this stuff was going on. And he says, I just wanted to thank you. Absolutely. He says, yeah, he says, yeah, I’m going to lose everything here. They’re repossessing everything. He says, and I’ve been in the oil patch all my life.
He says, so, you know, I’ve been broke before. He says, but this is the first time I’ve ever been broke with $2 million. Okay. So when you say what the backend looks like, I don’t know exactly what it’s going to look like. I can tell you for him, that was the perfect landing with his fully funded plan.
But let’s say that. I’ve had a successful business owner. He gets out to age 62. He’s got $3.4 million in the plan and there’s no more room. There probably will be, but let’s assume that there’s no more room and he takes that and he rolls it into his own profit sharing plan or he rolls it into an IRA. He’s already extracted the life insurance from the plan, you know, at least five years previously.
And so, he’s got these pools of money that he can have. If it’s in the profit sharing or the IRA, he can now change his investment strategy to make it grow a little faster. There’s no longer a limitation of how much can get paid out. So, he could take that $3.4 million and, you know, let’s say he jumped and he was earning 7% and the rule of 72, 10 years later, he’s got $6.8 million. Okay. He’s only 72 years old. He hasn’t even hit minimum distributions age at this point.
He’s got a life insurance contract that’s gone on. Well, you may have had some other growth in the limits in the cash balance plan. I just completed one this morning where he terminated the plan because he was fully funded in 2016 and it had a wonderful 2022 and we just put a plan in to soak up all the new. He’s going to be able to put $350,000 a year away for a few years.
So, there’s a lot of different end games that could come into play. But my experience is that most successful business owners want to have a pool of money that they access when they want. And since they probably have a lot of other tax paid money from the sale of their business or from rental income that they’ve you know, established with their profits over the years and so on that the pension money they’re going to take out as slowly as possible because they’re going to owe taxes on it, but they always have the life insurance product that was funded through the plan that they could get some more tax free income.
So, a little bit depends where they are in life and what they want to do. As you know, in our normal plan design study, we’ll show them taking money out of the life insurance over a level basis over 25 years, 26 years, and have a residual death benefit. And it all looks really nice. I don’t have a single client who ever did that.
They always want to know, you know, could I pull out a chunk of money? I want to buy a boat. Yeah, the answer is you, it’s your money, you deal with it anyway. The same thing is true with the pension assets or profit-sharing assets or IRA assets. You know what your tax position is, if this is a low tax year, it may be worthwhile pulling some out and just up to the next bracket level.
And that’s something that you guys do great, is help them plan for those distributions over time. And so, I think I mentioned to you that I do have a client who does take it out pretty much periodically. And that’s because he hates paying tax. And he’s in the required minimum distributions phase. And so, what he does is he pulls enough out of the life insurance tax free to pay the taxes on his RMD so that they look like they’re coming out tax free to him. So, there’s a number of strategies, Pat, that I think that will define the back end as we get closer to it.
Patrick: Wonderful. That’s fantastic. I appreciate all of that. I appreciate our discussion today.
Anything else, Bruce, that we should be talking about as far as cash balance plan goes before we wrap up?
Bruce: One of the things that you have to deal with, some people say, I heard that they’re terminating all the pension plans in the world. That’s what you read in the press. And I’m going to tell you why you read that. Cash balance plans have been growing at a 17% compounded rate for the last decade. But if you read the press, everybody’s terminating these plans.
And what you’re reading about are multinational companies and government plans and so on.
Now let’s take that multinational company. How many of the shareholders are employees that would be close to none? Well, cash balance contributions are a hit to earnings. I mean, that’s a deductible expense, but it shrinks earnings.
Well, as I recall, stocks sell at a price earnings ratio, so if you reduce earnings, you reduce price. So, if I’m a shareholder of that, I’m probably not all that excited about you putting a lot of money in that creates this expense. Since I don’t get any of it. Now, let’s flip over to who our clients are the closely held and professional business How many of them are employees of the company?
Well, that would be all of them and how many of them are rewarded disproportionately by those contributions? Well, that also would be all of them. So, it depends on which poll you’re in as to why you want this plan or don’t want it so in the multinational. There’s certainly a force moving away from it because of, you know, financial aspects for the shareholders, whereas in the closely held and professional marketplace, there’s a strong current toward them because of all the advantages that they get.
So, I think that might be a way to summarize why people like these plans.
Patrick: That’s fantastic.
Well, Bruce, I absolutely love talking to you about these, these concepts because you do such a great job taking a fairly complex topic and making it, simple for us to understand. So, I always appreciate that very much.
Bruce: And we appreciate working with you because you are good at the planning phase. You know, the success of any kind of planning is the data that’s collected. At the end, if you didn’t get it, all the data, the surprise data that comes in will always ruin the plan, if it’s too much or too little. And so that’s one of the things that we really like about you because you guys are so well prepared and you make a great partner for us to work with for helping clients.
Patrick: Well, I appreciate that. We, we do feel like to do good planning, you need to be completely plugged in. You need to understand the cashflow, the legal, the investments, insurance. Everything they’ve got going on, like, we’re projecting out our clients cashflow, like right now in last month in July, we’re, looking at, okay, let’s project out our tax liability so we can make sure that we’re implementing the plans.
We’ve got all the plans funded that we need to have funded, or at least a strategy to fund those. And so, I appreciate that very much. We work hard to make sure that there’s no surprises in the mix for our clients and they’re too busy. They have too much going on. So, we like to take as much off their plate as we, we absolutely can.
Bruce: You asked me a question about the ideal client. And I’ve often joked that the ideal client is not. Surgeon who makes $750,000 a year and on April 12th, he’s at the bank trying to borrow enough money to pay his taxes. He’s not a great candidate, so he needs somebody like you to help him control his world and make sure that, you know, everything comes out right at the end.
Patrick: Absolutely. Yeah, I know there’s so much truth in that. And to get off on a little tangent. People think if they earn more money, you know, it’ll solve all their financial problems. And we’ve had clients that make $2 million a year that are broke and it’s like, okay, we, we’ve got to find a way to start automating some of these things so your dollars are automatically going into, a savings account, whatever we want that to be, whether it’s a cash balance plan or brokerage account or savings account, something like that, just because people will spend what’s in their bank account, whether they’re making $30,000 a year, $2 million a year.
Bruce: Yeah, sometimes the discipline lacking is, is just more than you can overcome.
Patrick: That’s true. And we find it interesting. Our entrepreneur clients don’t have that problem. Yes, our doctor clients sometimes do have that problem. And I don’t know what that is there that causes that, but, uh, they don’t think the same way the entrepreneur does. You know.
Bruce: If you want a, a quick guess about the difference, you see the doctor is Fee for service. And he knows that he’s going to be there the next morning. And if he works an hour, he will get paid an hour kind of thing. Whereas the lawyer, whomever, whereas the businessman knows that there are times where he can really work very hard and lose a lot of money.
So, he tends to be fairly more cautious and better planned than the person who thinks that it’s just ongoing forever.
Patrick: That’s very true. That’s a, that’s a fantastic distinction, uh, because I’ve been there. You know, and that’s part of our story. We, we were on the mountaintop and then went broke and then, uh, you know, figured it all back out again.
Bruce: So, I mean, you know, and you know, it’s unfortunate that most of the time it’s some external factor. I mean, 2008, I had very little to do with what caused that. But I can assure you that it was impacted me like everyone else. I investments and other things that suffered.
Patrick: Absolutely. Well, Bruce, you’ve been wonderful.
I appreciate all of your time, your expertise, your insight, your ability to help us solve problems. It’s, it’s always a pleasure to connect with you. So, I appreciate all of this very much. And, uh, you have a great day.
Bruce: Thank you too. And a wonderful weekend. I appreciate the kind words, and I have the same to offer to you and your colleagues.
Patrick: Thank you for joining us. And don’t forget to rate and review our podcast wherever you listen to your episodes. The Vital Strategies Podcast is produced by Bright Bell Creative. The music is done by my friend Cephas. You can download his music on Spotify or wherever you like to stream. Research and copywriting by Victoria O’Brien.
If you have any questions, topic suggestions, or if you’d like more information on how we can help you grow your wealth and achieve long-term financial success, visit vitalstrategies.com. Have a great day.

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