In this episode of Anderson Business Advisors, Toby Mathis, Esq., speaks with Jeff Mason and Chris Hammond from Redwood Retirement on the intricacies of $100,000+ cash balance retirement plans, focusing on how innovative solutions can benefit business owners. They explore the key aspects of these plans, including what can be paid and deducted, the hurdles involved, and the flexibility they offer. The discussion covers the effectiveness of Redwood’s solutions, highlighting when payments are due for the tax year and showcasing best-case examples of significant tax savings achieved through cash balance plans. Chris and Jeff also clarify the differences between Cash Balance Plans and Defined Benefit Plans, explain the limits and maximum contributions, and introduce a sample plan for effective modeling. With insights into flexibility, payroll funding, and real-world case study outcomes, this episode is a comprehensive guide to leveraging cash balance plans for optimal retirement planning and tax efficiency.
Highlights/Topics:
- Chris and Jeff intro, Redwood Retirement and their cash balance plans
- Liability – what you can pay and deduct, hurdles, flexibility
- Redwood’s solutions, proof of effectiveness
- When are payments due for the tax year?
- Best case examples of cash balance plans and their tax savings
- Definitions and differences – Cash Balance Plan vs. Defined Benefit Plan
- Limits and maximum contributions
- Modeling a ‘Toby Mathis plan’
- What all this means for business owners
- Flexibility, funding with payroll
- Favorite case study outcomes
- If you want to speak with Jeff and Chris – click the link below to see if their services can help you!
Resources:
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Full Episode Transcript:
Toby: Hey guys, Toby Mathis here today and I’ve got two guests on today, Jeff Mason and Chris Hammond. Welcome, gentlemen.
Chris: Thank you, sir.
Toby: We’re going to be going beyond the 401(k), and we’re going to be talking about plans where you can put in over $100,000 a year and why it’s important that you know about this. This is not a secret in certain communities. It’s just a secret out there in the world in general, but in certain circles, it is certainly understood and utilized very effectively. That’s using defined benefit plans. Gentlemen, if you’re willing to maybe give me just a couple of minutes on who you are and what you guys do.
Chris: Hi, I’m Chris Hammond. I’m managing director and co-partner with my partner, Jeff Mason, and we own and operate an actuarial firm that specializes in cash balance plans, which is a form of traditional defined benefit plan that kind of couples with 401(k)s and hybrid type. We consult and administer plans all over the country, and we have actuaries in multiple states. We basically consult and help business owners save massively on taxes, and we take a very unique approach to how we structure a cash balance plan for business owners.
Toby: Jeff?
Jeff: Like Chris said, I’m the managing director as well at Redwood Retirement. Like I said, I like to take this hands-on approach with our clients and guide them through the tax burden that they have by using the tax strategy of a cash balance defined benefit plan and managing their cash flow. I don’t have to be pushy about this. This is about saving taxes, taxes, taxes. We love that hand holding approach to how we deal with people.
Toby: Let’s demystify it so if you’re listening, you’re probably going, what the heck does that mean? It means that we can contribute into a tax advantaged account, which means you get a deduction this year and you can contribute in some cases over a million dollars, generally speaking, probably in that $100,000–$300,000 a year range. I’ll let these guys go over what those limits are and how you calculate it. But I’m not joking. You could be making $200,000 a year and you can contribute pretty much the whole dang thing into a retirement plan by working with an actuary and an actuary gentleman. Does somebody want to take a crack at what an actuary is?
Chris: We’re basically talking about what we call a pension plan. Back before the current state of things, when a pension plan was all retirees had to rely on, they worked at a company for 30 or 40 years, and the company gave them then, ongoing income stream for life after that. What an actuary does is basically say, okay, well, we have all these employees, this workforce and owners, what kind of benefits are we talking about? How long do we have to pay them for?
An actuary is basically looking at mortality and interest and financing and discounting to project what is that income stream and liability stream is going to look like for the next several years or decades, especially with very large corporations. In modern times now, we’re talking about small business owners, doctors, dentists, chiropractors, lawyers, engineers, and successful small business owners in any trade that are looking at how much can I accumulate in a very rapid period of time while still providing benefits for my employees. The more I provide for my employees, the more that allows me to put away as well.
If you’re in the unique situation of not having employees, the rails are off. There’s a lot you can do. There is a limit. We’re going to show that. But basically, an actuary is someone that is well versed in the mathematics behind these things. These are very complicated under the hood. No one ever has to see it. We work with the actuaries directly. We direct them and consult with the client and basically get down to what’s going to work for your situation.
Toby: Jeff, I’m going to ask this of you. Let’s say that I’m making $300,000 a year and I’ve done this for a long period of time. Maybe I’m 15 years or 20 years into my career. I’m getting older and I’m like I don’t need to have all that money every year. I already have some savings. Maybe I’ve got some real estate. Maybe I’ve got some other investments.
What’s a typical range of how much I could put aside tax-deferred? I’m going to get a tax deduction for this, but let’s say I make $300,000 a year, 50 or 70 years old, what’s a typical range that I’m going to be able to put aside?
Jeff: Individually, you’re probably $200,000 all the way up to $350,000 year after year. If you wanted to in a really big year, you could put in quite a bit more than that. I have two quick analogies that will kind of explain what a cash balance plan is.
Chris and I have broken them down to two very easy analogies. First one, let’s think of it as a savings account. When you go to the bank, you ask yourself two questions. How much am I going to save and how long is it going to take me to save it? Let’s say we’re going to do a million dollars over the next 10 years. Our savings account would be $100,000 plus some nominal interest because that’s what the IRS required with the cash balance planner. Each year we’d put in $100,000 plus nominal interest. If we design it correctly, maybe we put in $300,000 and we get ahead of our savings account.
If the business owners have a down year and a low tax liability, maybe we only put in $50. That way the savings account can complete itself, but we’re still on track. The design in the front end is very important.
Toby: Yeah, so I don’t want to interrupt you, but we’re targeting a million and so you just said $300,000 might be the first year. Let’s say, hey, we need to hit a million and you don’t have to put in $100,000 a year. You could put in $350,000, $75,000, $200,000, or $100,000. You could actually space it around and that’s pretty flexible?
Jeff: Yeah. Obviously there’s some limitations to that. That’s the second part of the analogy. Now let’s think of the cash balance plan for the business owner as a credit card. That credit card is going to hold the savings accounts from the last analogy. Then each year, just like you get your credit card statement, you’re going to have a minimum due and a maximum credit card limit. For the cash balance plan, you have an annual minimum due and a maximum deductible for your company, the company that’s sponsoring the plan.
Just like when we’re having a good year as a business owner, what do we tend to do? We tend to pay our liabilities down. You would pay more on your credit card. You probably pay closer to the maximum limit for that year and when we’re having a down year and a lower tax liability, we’re going to pay probably closer to the minimum to control our cash flow.
That’s exactly what happened in your question. If someone wanted to put in a much larger amount, we’re going to give them the range for their credit card statement each year. Obviously the opening year, we know exactly what we’re doing because we’re designing it from the beginning. We can project that for them where most firms don’t take the time to do that.
Toby: This is just so we’re clear because you’re saying paying a credit card, you’re paying into your retirement plan. This is where people’s brains break. We’re so used to it that I could put $7,000 a year in an IRA or I could put $23,000 a year in a 401(k). This is the same thing ramped up and instead of calculating how much we put in, we’re calculating how much you can build up and receive based on your income that allows us to hit a certain dollar amount. Chris, maybe you could elaborate on that. There’s a gap, right?
Chris: Yes, that’s exactly right. The credit card analogy is that unlike a 401(k) where you’re just contributing a defined contribution, this is we’re designing the benefit. We’re saying we’re going to give Toby a benefit of $100,000 every year for the next 10 years. You haven’t put a dime in yet, but we know we’ve got a million dollar liability that’s going to accrue over the next 10 years.
To Jeff’s point as a credit card statement again and, back to the actuary with the actuaries doing at the end of every year is he’s balancing where do assets stand based on contributions and investment returns versus that liability that we designed. Based on that, it creates this minimum to maximum payment range.
We like to explain to clients because they do, they get their brain scrambled by that, but when you say it like that and they understand. This minimum you’re always telling me about, that’s like paying the minimum to the credit cards. I can do that because I have tight cash flow, but it’s not really making progress towards that liability. Whereas if I’m doing great this year and my god, my taxes are going to kill me, but I could put $400,000 and that’s going to reduce my tax taxable income, yes.
Toby: Now if I’m a business owner, I’m sitting there, and the first thing I’m thinking is you just created a liability of a million dollars. Do I have to pay the million dollars or do I have flexibility? Do I have the ability to modify this thing? Am I completely toast? Am I having to pay this all the time? Or do I have some flexibility? What are the kinds of guide rails? Maybe I’ll throw this at you, Jeff.
Jeff: When we set up that savings account for each individual in the company, let’s just say we have an owner [inaudible 00:09:25]. We have no employees. It’s just the business owner. What occurs is let’s say it is a hundred thousand dollars. If we paid ahead, now that minimum could be zero. If we put in $300,000 and we’re tracking and we should be at $200,000, that minimum might be zero, but we still have a liability that we could fund into, right? That might not be the case in every situation, but that’s where we help forecast and show that.
Toby: It’s almost a pretend liability. It’s like, this is how much I can put in and so when you say liability, that just means here’s what you can pay in deduct. Is that fair?
Jeff: Exactly. As long as we follow the guidelines of the IRS or the parameters that we set when we design it, and then yes, that’s flexible every couple of years, we could change that. Obviously, the IRS is going to put the no no finger if you start going dramatically up and dramatically down and stuff like that. We’re going to try to stay consistent. We’re hoping that we can start out somewhere and then maybe enrich the benefit. It’s a lot more fun for everybody when you do that.
Chris: Another way I would say it to be real quick. You stimulated another analogy here. Think of this 10 year analogy and $100,000 a year as hurdles. We’re projecting that if the design is comfortable for the business owner today, that’s what we’re going to lay out. Halfway down the lane, they might say, you know what? I need to put in a lot more or that was too rich for me. I need to pull back. I’ve lost a big contract. We can pull back. We can adapt as we go.
But so the liability really is once you go over each hurdle, that liability then is locked in. Does that make sense? We’re looking at a million, but you get through year two, you’ve really only accrued $200,000 or whatever we’ve designed and you’re paying that.
Even then, there’s flexibility. You want to fund because you’re saving up for retirement. You’re trying to take this tax deduction, but even in a bad situation, when COVID hit everybody went oh no, now what do we do? Restaurants are closed. We can’t put any money in. We have no cash flow. If you close the plan, if you have employees, the employees will get a 100% of that liability that was built up for them. They’ll get paid first.
The owners take the hit and it’s not that they’ve lost anything. Maybe they’re $700,000 liability at that point and they’re only at $500,000 in assets and they have nothing to fund. As long as they meet the minimum for that year, which is crucial, they can say, okay, we’re going to close this. We won’t get our full share. We’ll take what is remaining that goes towards us. They’re able to waive their liability at that point as long as they’ve met all the yearly minimum.
Toby: But if this is a closely held company with two people in it, you’re not worried about that. This is if you have a bunch of employees that you’re contributing to as well. This is a benefit for those employees too. It might be that you’re getting 90% of the benefit and you’re giving them 10%, but you are giving them a nice retirement benefit and it is deductible.
Jeff: Exactly.
Toby: Is that pretty close? What’s the benefit that usually goes to the owner? What’s the range that you generally see? Is there a magic number that most people want?
Jeff: What do I mean by his contribution or percentage back to them?
Toby: Percentage back.
Jeff: Percentage back is I’m always shooting for 90% or more. If you have a lot of employees, that percentage is going to go down naturally, but that’s my goal. Usually even if you have employees, if I don’t get you to 80% going to the owner and family members, typically we’ll add the wife or use the rest of the tax strategies available. If I don’t have 80% going back, I’m pretty upset.
Toby: But let’s say that I’m putting aside, I’ll just use a round number of a million dollars. This is somebody who would definitely have been hit at the 37% tax bracket. They’re like man, I’m going to get $630,000 that I’m going to keep after Uncle Sam takes it. You’re putting a million dollars into a retirement plan where you’re getting 100% of it. It’s going to grow tax-deferred for god knows how many years and it’s going to come out. It’s going to pay tax. But that’s going to be a sizable amount.
When you take a 37% tax hit, I forget what it is, but it’s close to 60% that you gotta make to make up for that tax hit. It might be even more. You’re way ahead of the game. You’re just like, is that the right way to think about it?
Chris: Yes, dollar for dollar and we show that we show this in our concept designs when we’re scouting prospects for who this is going to help we’re showing them here’s our solution and here’s how it works. If you want proof, we have that too. If you were to stick the after tax equivalent into a retail brokerage account and trade that instead, apples to apples. And even with variants, we can show how this is way better because of what you just said. But we show the effect of that pre tax deferral.
Toby: Yeah, and you guys are number crunchers so you could actually say, here’s what it is. But most people think like me, I drag my knuckles. I’m like, alright if I can write off a $100,000, I’m going to save myself 30 something percent tax benefit going to save me thirty some thousands. I’m looking at it from that standpoint. Most people are probably going to do the same.
Two big questions and then I want to go through some case studies. Question number one is when do I have to pay it? If I’m doing this for 2024, do I have to make all these payments in 2024? Do I have some leeway?
Jeff: If you’re a corporation or any pass through entity, you have nine months after the calendar year if you’re a calendar year company. You have to [9-15-2025 00:15:23] to fund 2024. We still have 2023 clients that are opening up right now and they’re not due to 9-15 of 2024.
Toby: Okay. I want to explore that real quick. I can set this plan up even after the tax year. So if I am in 2023 and I’m before September, this video probably comes out just before that, I could still set up a plan and actually make contributions for last year and lower my tax liability.
Jeff: Yeah, absolutely. If you have no employees, we can go all the way to September first and we’d need some time to open accounts and get documents in place and all the signatures. If you have employees, probably like August 15 probably is the general timeline. I know last year you pushed me to some clients and we went right there on the deadline. I think we opened up accounts at 9-14. That was one. It was an owner only and I think if he wouldn’t have been out of the country, it would have gone really really quick.
Toby: Now let’s just say I could be doing this for 2023 right up against the wall there. What if they’ve already filed their tax return? Are they toast or can they?
Jeff: No, they can amend. They can amend, but that’s weighing the pros and cons of amending and doing that. But in some cases, it could make a lot of sense, especially now this is pushing them into QBI and other things by utilizing it.
Toby: It is a deduction so it does change some of that total tax calculation. That’s why you have a large number of people. They say if I do this, what’s the overall impact and it sounds like you guys are good at that analysis.
Jeff: I love to tell people what is the rate of return is when you write a check to the IRS. That’s my favorite thing in the world. It’s zero, right? When they’re like I have to put it in this account and I can’t get to it right now. I’m like you just got a zero rate of return. I’m telling all that money is going to be in your name growing for you over time and you’ll get to it later. You are ready to check the IRS. It’s never coming back.
Toby: Now, what are you guys putting this in? Is it just sitting in a checking account or savings account? Is it earning interest? What kind of financial instruments can we use when you open up?
Jeff: We’re going to use normal qualified funds. We’re going to use bonds, ETFs, money markets, if needed for sitting that cash and then stable value and then there’ll be some equities, but we want something that’s going to grow really slow.
Then for our advanced designs, we’re going to use life insurance if it fits for that individual because obviously there are some parameters to beat to qualify for cash value life insurance, but it’s what we utilize this for is we can build a Toby’s favorite thing in the world, if you watch any video, we can build an asset with this cash balance.
You can actually fund a life insurance policy pre-tax, which is the most beautiful thing. Then there’s a mechanism to get it out, which might be too advanced for this podcast alone, but that’s where we’re going to begin and open that window.
Toby: This is where it gets fun. I imagine that you’re manipulating the cash value to keep it as low as possible and I say manipulating, I mean, you’re picking policies that have the lowest cash value at the beginning so that in year five or six, whatever, maybe you’re buying it out of the plan at the cash value marker, which is this fair market value.
Now the policies are out of the plan and now it really starts to hum, it’s all inuring to your benefit where you can get access to it through policy loans. You’re not paying tax on it. Holy cow. That sounds pretty tasty if I’m an investor, wow. I like that.
Let’s shift gears here just because I like examples. Do you guys have any examples of people that you’ve worked with or favorite cases where it can really hit home for people where they might say hey, that sounds like me.
Chris: I think we’ll build one for you on the fly in fact.
Toby: Let’s do it.
Chris: We’ll do the Toby Mathis cash balance plan.
Toby: I still call them tax defined benefits. I have a bad habit. Are they the same thing? Are they different?
Chris: A cash balance plan is a defined benefit plan, but it’s another class. Traditional defined benefit plan is structured a certain way. Again, looking at long term liabilities, a cash balance plan is a liability builder like we’ve been talking about, but it is more of an annualized budget. If you want to think of it that way.
Toby: Then let me ask one thing. You can pull up your screen. I want to see what we’ll do. Let’s build one. What’s the most you have right now of somebody putting away per year that’s tax deferred?
Jeff: We have one client where we’re putting in $1.2 million for 2023. It was between the husband and wife who are very young and the mother. It was a game changer for them tax wise, because they were sitting with a very, very large tax bill.
Toby: If I’m not mistaken, are we talking about tax savings of over $400,000?
Chris: Yeah.
Jeff: Yeah.
Toby: I’ll take that.
Chris: Even better than last year. His max for this year, I may not let him go all the way to the max, but his max for this year is $1.7 million.
Toby: Holy [inaudible 00:21:16] but there’s a total amount that they can put into these plans. These plans, I can’t have a Peter Thiel Roth where I got a billion dollars in it or $2 billion or whatever the heck these things accumulate. These things have a, this is the max you can have in it and if not bad things happen, right?
Chris: That’s right. This is one of our exceptional clients that just kills it in his business. When I do this first two tiered example for you, I kind of interlace this story because it fits.
Toby: Let’s do it.
Chris: But they’re just in the situation where they’re able and needing to contribute a significant amount. Between the husband and wife and mother with no employees, they have a lot of latitude where they’re able to do that. We have plenty of other clients that are also sticking in, $400,000, $500,000, $600,000, or $700,000 in a given year or even up to a million over a couple of years. It’s not all the time. It’s not every year. I want to be very clear about that.
This isn’t something where we’re going to tell you, you can put in a million dollars a year and for the next 20 years, you cannot. But in the right situation, when it makes sense for you business wise and tax wise, you have the latitude in this plan even if we give you a nice linear design to start with, you have the latitude in a given year to suck away six or seven figures at times.
Toby: Then what’s the maximum amount? Like if I did this and I was a single owner, I’m in my 50s. What’s the max I could put in this type of plan total?
Chris: The max that someone can do right now, it’s based on a number of factors, but the max someone could do as of right now, the IRS does limit what you can accumulate in a defined benefit pension plan or cash balance pension plan. Right now is $3.5 million. If somebody is retiring today and they had that and their limit supported it, their individual limit, they could walk away with that amount. It’s index so it goes up every year.
The nice thing about our software that I’m showing here on the screen is we’re actually projecting for where that limit is going to rise to within reasonable assumptions. We kind of know where someone 10, 15, or 20 years out from now where that’s going to take them. Based on that, we can design around that outlier and then back fit it to what’s going to be comfortable for them and suitable for them with the flexibility added that they can go like, Jeff said, low years, they can contribute zero to a very low amount depending on how well funded they are or to a very high amount if they, if they are able.
Toby: This sounds like it’s a good tool to have in your toolkit and if you have a great year or you’re somebody, especially that’s had a great career and you’re 15, 20, or 25 years in, and now you’re like, shoot, I’m getting killed in taxes. This is a great way to say you know what? For the next 10 years, I’m putting my head down. I’m not going to pay the tax man. I’m going to put it aside for myself. I’ll gladly pay the tax man over the next 25 years as I use the money in my retirement. Is that [inaudible 00:24:14]. Let’s go through an example. Tell me what you need from me?
Chris: Alright, can you see the screen okay? The little blackboard here.
Toby: Yeah, I certainly can.
Chris: Alright. I’m going to walk you through kind of quickly. You can see over here, I have a compensation list. This is looking out for the next 11 years of a $100,000 and we’ll come back to this because I want to illustrate some of the things we’ve been talking about. But let me first go over to the assumption page.
If we do a model of Toby Mathis cash balance plan, and we will do $100,000 in W-2 comp. It’s important to note that compensation is used for retirement plan calculations. If you are an S corp or C corp, it has to be W-2. It can’t just be your net income from the business. Unfortunately, there’s a payroll tax component to that, but we’re going to show why it’s worth it when we get into this.
If we do years at $100,000 in W-2, let’s say, we’re talking about the next 10 or 12 years, and we set the benefit at 100% of comp just to start. We’re going to say that’s $100,000 annual benefit like we were talking about so looking forward to the liability.
Then that gets an interest credit added to the benefit amount so the liability, like a credit card, is accruing at an interest rate. These are benefits you owe yourself. That’s why we call it your credit card, but you’re going to end up funding toward that benefit.
The idea is that you’re going to match the investment return objective to that interest credit because you’re wanting to fund pre tax dollars into the plan to hit your annual benefit and then you’re wanting your investment portfolio to keep track of this interest credit that the benefit is growing by.
What we’re going to do is go over the blackboard here. I’m going to demonstrate that really quickly. Just looking at the benefit real quick. That’s this blue line here. We call it the blueprint. We’re still at day one. But we’re looking here 11 plan years out so 2023 and then the next 10 years forward.
This is a $100,000 benefit each year growing at 3% on that accruing liability. This is really just the blueprint. It’s the target. This does not mean where we have to end up or anything like that. It just is the axis that everything’s revolving around.
Before we go further, let’s step back and I want to talk about the limit. Now the first thing I want to do is go back to that assumptions page and like you started out saying, as an example, let’s talk about like $300,000 or something like that. In fact, the IRS allows, even if you’re making $500,000 in W-2, they limit how much compensation can be considered in a given plan year. Right now that limit is $330,000. I also want to make a larger benefit so we’re going to double this.
Toby: When you’re doubling the benefit, you’re saying, how much am I putting into the plan each year? Am I putting in $330,000 or am I putting in $200,000?
Chris: We’re going to make compensation, $330,000. The benefits are going to be $200,000 a year. Now instead of 100% comp, we’re looking at 61% of comp for you.
Toby: Okay, we’re putting in $200,000 a year.
Chris: $200,000 is the benefit. Now let’s go back to the blackboard because I want to show the limit this way, this IRS grand limit, grand ceiling on what someone is able to do. For you looking forward to a retirement age of 62, which is what we’d like to do, it can be 65, and certainly no one has to stop at those ages. They can keep going for many years after that. But we anchor it to this because going back to what does an actuary do? An actuary says, where do we need to be at retirement? And then discounts everything back to your current age.
Based on that and projecting to retirement, we’re seeing that $3.5 million that the IRS limits someone to right now in 11 years from now, and based on $330,000 and comp and we’re 10 plus years in the plan, you’re looking at $4.2 million that you could accumulate. A little over $4.1 million you could accumulate.
Toby: All tax deductible. That’s all tax deductible contributions plus some tax growth, right?
Chris: Right. What I want you to think about and everyone watching is, this is not what you have in the account or what you will have in the account. This is the ceiling on what you can do at any point along the way, so if we build this and someone says, can you redo this and show me what it looks like in seven years? No need. Slide back down the graph to seven years. This is where you can be.
Toby: That’s the max that I can contribute for that period of years.
Chris: If you got to year seven here, you can see it says just under $2.2 million. You got to year seven and you had $2.5 million in it, for example, we need to wait another year until that limit catches up. We don’t mind as long as you have a long-term outlook. We don’t mind if your assets get a little bit above this red line. We don’t want you way up in here because you’re just inviting a disaster. But in the end, we don’t want to exceed this red line. Everything above it invites a 50% excise tax and ordinary income. This is the most the IRS will allow you to take out of this plan when you shut it down.
At 62, we’re talking about $4.2 million. Now, how do we get there? Alright. We talked about doing a $200,000 a year benefit now. This is the baseline. If you said I’m perfectly comfortable putting in the same amount every year, I’m perfectly comfortable with an investment return of 3% and some people might say, well, 3% is pretty low. However, we can’t exceed this red line. If I’m annualizing 12%, what do you think is going to happen to assets?
Toby: These are assumptions though, right? The reality is that you’re targeting 3%, but you might be doing bonds that might be doing 4% or 5% right now.
Chris: You could be doing higher. You could be doing lower and that all comes out in the wash when we do the actual calculations. But what we don’t want is someone to say oh, wow, Toby’s putting in $200,000 a year. I want to stick that in Tesla or something. All of a sudden your assets are way up here that you can never get to.
We’re looking for conservative returns, low volatility, because the idea is you want to be able to put $200,000. What if you put in three years of $200,000 and your advisor took you out and got you 40% returns. You’re going to be way up here. All of a sudden the actuary is going to say he can’t stick anything in. Now year four, five, six, seven, you can’t put contributions in to take tax deductions on.
Toby: That’s because based on that growth, you’re going to be at your max in. That’s right so we can’t contribute anymore. It doesn’t mean that the plan’s toast, it just means that you can’t put more tax-deductible dollars into it.
Chris: That’s right and you have a risk of paying excise taxes and ordinary income taxes because if you take it out at any given point in time along this curve, you can’t exceed this ceiling. This is what the IRS says is your limit.
It’s different for everybody by the way. It’s based on the number of years of participation in the plan. How old you are, how far away you are from retirement, all those kinds of things. What your average compensation is, that’s a big driver.
We really are saying you’re talking about the 37% tax bracket, if you want to be able to put in multiple hundred thousands a year or even up to seven figures in some years, you don’t want the returns robbing you of that opportunity. Someone says, I heard 3% or 4% return. That seems very low. Well, it’s because we’re getting the return in the tax deduction.
Toby: When I look at it, I’m saying, hey, if I get a 4% return, but for every dollar I put in, I’m saving 32 cents in tax on, then realistically, I’m getting a 36% return.
Jeff: That’s right.
Toby: If you’re making $100,000 a year and you’re in a lower tax bracket, then it may not be worth it, you don’t want to go to zero. You’re probably closer to $200,000 or something where it really starts.
Chris: You’re 100% right. The higher the tax situation, the more this benefits you. It doesn’t mean you can’t benefit, you will benefit. But Nevada, 37% and 0% state. Okay, that’s not high, but it’s not terrible. California is 37% plus their state, which can be 11.9%, 12.9%, 13%. They’re over 50%.
In an extreme case, someone in the top marginal rates in state and federal are going to benefit the most. But anyone is going to benefit from the pre-tax basis of this, just like in your 401(k). What I want to show, though, is going back to our blackboard here. Again, this is the credit card that’s accumulating your benefit over the number of years growing at an interest rate.
The target of the investment is Toby’s going to put $200,000 in every year and you want the net return of your investment portfolio to closely match that. Let’s just say it exactly matches that. You can see now that the green line is the actual assets in the plan. In a perfect world, if we said we want $200,000 a year at 3% and you did exactly that, obviously that’s not ever going to happen. But if you did, that’s what it would look like.
Now, if you said, okay, that’s great. But what if, like you said your assumption is 3%, my advisor put me in a portfolio and the alpha was pretty good and I actually got 6% instead of 3%? What does that look like? And is that going to get me into trouble?
Toby: What does that do?
Chris: Okay, not so much. You’re above your target, which is good. The actuary is going to look at the plan assets at the end of the year and they grew faster than the target was. It’s robbing you some, but you’re not in trouble and you still have room to fund more over time, above and beyond your target. All we care about is developing a target that’s comfortable for somebody and then having a lot of room to give them that latitude if they need to fund a bigger amount in a given year.
Toby: Can we play with that? Let’s say that right now I’m like killing it and I want to put half a million dollars a year into the plan. Is it possible to model out what it looks like? If I did it, hey, you did $500,000 now, but maybe you’re going to do $200,000 next year. Maybe you’re going to do $100,000 the following year. Is that something?
Chris: Yes, what I’m actually going to show you is in the end, you can see here at 6%, let’s say we did, you’re just under $3 million, but you can go all the way up to over $4.1 million. You still have $1.1 of room here that you would like to fill up with contributions.
Toby: I don’t even have to go down in a year. I could just say hey, I’m going to add an extra $200,000 or $300,000 for four or five years.
Chris: As long as for that year, the actual calculations board out and said because every year does have a max on what you can contribute and it’s based on a number of variables and changing interest rates and all that. But that’s what we’re doing.
Jeff and I, every year, give clients an illustration that says this year, based on where assets stand and total benefits stand, you must fund at least this, which if you’re well funded can be zeroed and often is, and you are able to find up to this amount.
Based on a number of dynamics, that range fluctuates. Like we were telling you in a couple of those cases, we have cases where it’s $1.7 million for one of our clients right now, after he put in $1.2 million last year, that’s a very big case, but yeah, it shows that kind of flexibility.
Toby: But they’re not going to be able to do that for 10 years. They would blow through the seal.
Chris: That’s right. You’re really looking more like a situation like this where you have a plan and you’re kind of sticking to it. Maybe you’re putting $200,000 in for the first three years and then like Jeff said you have a tight year or you have some other project you want to put your money into, and maybe the minimum afford you to put in zero that year or very low amount. You don’t have to stick to the plan and returns also can vary, obviously.
These lines, the actual returns and such, will shift. But yes, you still have all this room in years when it makes sense to do so, especially tax reduction-wise, where you can put in larger contributions all the way up to the point where we could fill up this bucket. When I put this red line on the graph, that’s what I’m building. I’m building the bucket for that owner.
Jeff is consulting that business owner and saying, where do you stand? Where do you see yourself? What’s the long-term outlook? And based on that, we will size this bucket accordingly.
We jumped comp all the way up here to $330,000. What if we didn’t have that comp? What if we said, well, I like that benefit and it looks good, but I don’t want to pay that much in W-2. I don’t want the payroll taxes and such. Here’s going to demonstrate why that’s so critical because now your plan fails.
If we only put $100,000 in W-2, for some people that might work perfectly, but for this situation, if you wanted to put in $200,000 for 10 or 11 years, you’re not going to be able to do it. You crashed that ceiling right here.
Toby: We’re not talking like you could, again, you could put the entire amount of your W-2. You just have the employment tax, which means it’s just a billion survivors, 12.4% Medicare is 2.9% total of 15.3%, half of it’s deductible so it’s 14.1% percent or thereabouts, but it phases out a portion of it. The 12.4% phases out at, I think, $167,000 it’s indexed for inflation so every year it goes up, but you have a portion that you’re going to be paying employment taxes.
But that’s okay because in theory, you’re paying into social security. You’re going to get it back when you retire. In theory you’re basically funding your own retirement plan, although Congress spends the money, but you have a benefit that you’re going to get. That’s the price that you pay, right? It’s like okay, I just have to pay it through payroll to fund this, but I could do [inaudible 00:38:07].
Chris: Here’s the thing, the news isn’t that bad because a lot of your clients, I’m sure try to keep W-2 fairly well contained because they want that cashflow for other investments in other projects. Someone’s saying, well, I want to keep my W-2 at $100,000 or even less. That’s fine. Right here it doesn’t work. But you don’t have to have that $330,000 every year to get that limit.
Let me show you what the IRS does. The IRS says you’re able to put in $330,000 in comp. It’s this year one here where you said at a hundred, but it’s three $330,000 for 2023. For 2024, the limit is $345,000. Even if you’ve made $500,000 and Dennis has $500,000 W-2, it doesn’t matter. We can only use $345,000 of that in this limit calculation and for prop sharing and other things.
But here’s what it looks like we’re indexing going forward. The IRS usually increases that compliment about 5000 years, sometimes more, sometimes they don’t, but usually in the next 11 years, we know that this is what it looks like.
If you took W-2 of these amounts every year, this is the limit you would get to what we saw $4.1 million. Same as if it was $330,000 every year. We saw that too. But no, if you want to be at $100,000 a year in W-2, but you also want your bucket to be big enough to do this and have room for bigger funding in the future.
In actual terms, we only care about three years, a high three. Here’s what that looks like when you do that, here’s a hundred thousand every year, except for in this bubble right here. Here we need to dump, we need to pump up W-2 in these three years, pay more payroll taxes, but you don’t have to do it for all these years. Look, the limit’s the same.
Toby: What does that mean for a business owner? Does that mean like oh my gosh, I’m going to have to pay myself $100,000, a $100,000, now for three years, I’m going to have to pay myself a million bucks worth of payroll.
Chris: If like you said, that’s the cost of doing this. If they don’t, that’s fine. But then they’re limited to about $1.289 million.
Jeff: But we can find a happy medium between that. If they’re really comfortable with a $100,000, but let’s say they could do $250,000 for that three years and raise their average and so then.
Chris: Let’s do that.
Jeff: That’ll get them somewhere in the middle. It’s a give and take. It’s about cash flow.
Chris: Would you say $200,000?
Toby: $250,000 I said.
Chris: Alright, we’ll do that, $250,000.
Jeff: There you go. $250,000 works, right?
Chris: Now your plan works and you have a little bit of room here because your returns were too aggressive. If we back off the return and stick to what we told you, the goal is 3% because this is a tax deduction play.
Toby: So we’re doing bonds or something or we’re doing something that just grows.
Chris: Now you still have room to over contribute in years when you really need to, and otherwise you can just stay right on track.
Toby: For business owners that are watching this and you, your brain might be aching a little bit going, oh my gosh actuaries and lawyers. I think I’m going to stab myself right there. The point is that you have the flexibility if you’re going to fund this, you’re funding it with payroll.
Hey, I’m not putting $200,000 aside with my rental income. I’m putting $200,000–$250,000 of my W-2 income and I’m not paying tax on it anymore. The only thing you pay tax on are the employment taxes, which again, phase out on a portion of it. Medicare never phases out, but you end up paying very little tax depending on what your other income is, especially the high income spouse.
If you have another job or you have lots of W-2, especially you folks out there that are making $600,000 or $700,000 a year W-2, it ultimately, what we care about is scraping off the highest tax dollars that are at the higher end of your income in jamming them in taking a deduction on those and jamming them into a cash balance plan. Is that fair?
Jeff: Yup, absolutely.
Toby: Before we go because I think we’re a little bit over, is there a favorite case study that you guys have that you’re like hey, this is a really great case study. These people were doing X and what a great result we have, and they just, they just killed it.
Chris: Let me do this because this really will help understand the case studies that have happened and why they got to that route to start with. Let’s take you back to your limit here and you’re trying to fill this up. What did we have for $200,000? Okay, you’re going to be able to fill this up if you’re able to because that’s again, what we like to tell people the most is this is their ceiling. They can fill the bucket up all the way with tax deductible dollars.
But what Jeff and I like to show people what this is, is why is this so valuable? We show here what that actually projects out to for that business owner. Again, this $3 million, that’s at 6%. That’s that the green funding line is not the red line. It gets much higher. We can take you all the way up to $4.1, for example.
That equates to about a $236,000 income stream for life. When you asked about a pension in the beginning, that’s what it used to be. That’s what that roughly equates to. Most people then, when they shut this down, they roll over to an IRA and manage it, or have it managed. But here is an illustration of the effect.
These after-tax dollars going into a retail brokerage account end up much lower than what this pre-tax does for you. What we show in a concept design, when we send a two-page concept design for a given prospect, is what’s the advantage of doing this? In this case, without going all the way to your limit, you’re at $645,000 better off because you did this. The net tax savings is about $770,000. This is after all fees, expenses, and taxes, everything. This is the net. This is after. This is the $2.9 million and you’re walking away.
Again, it comes down to effective tax planning, but that’s what we’re looking at. For those cases that we have and this is what I wanted to tell you about when we started out with the $100,000, the guy we’ve been telling you about, they were taking very low W-2, but he was making so much in his business and his advisor was bringing back 20% and 30% returns and kept saying we need lower returns if you want to make contributions to reduce your taxes.
I finally got to bump up his comp and all of a sudden, instead of being able to put in $200,000-$300,000, he had years where he could put in, like we said $1.2 million last year, $1.7 million this year because he did that and opened up that ceiling for him.
Toby: It’s always the last three years that they’re looking at on comp. Is that what they’re doing?
Chris: No, it’s the highest three over the whole time horizon. It’s as we go. In 2023, if we’ve had a plan for 10 years, what was their highest consecutive three year period in that last 10 years? That’s one of the drivers.
When we’re getting that across is your while you’re telling me you want to contribute more and take a bigger tax deduction, but you’re not taking enough in pay to make that possible. His limit was way down here like what we were looking at a minute ago. Bump that up and all of a sudden he’s got room. Not only that, we did it for him, his wife, his mom, they’re going to be able to end up putting away about $10 million dollars in the end. They’re at six right now.
Toby: That’s between the three of them though.
Chris: That’s between the three of them.
Toby: That’s right. Mom’s obviously, she’s older, so she’s going to have a much shorter time horizon. How many years of funding is she doing?
Chris: She will probably be in for the next seven years still. They’re young, but as long as they have her in the plan, it helps them as a family group. But that’s a case in point. You said spouse a minute ago. If you have a business out there and it’s owner only and the spouses can work together, this limit is just you. Your spouse could have the same limit given the same parameters. It’s really a big play on that.
Toby: The easiest way to look at this, let me just take it home, is if you are a small business owner and you have an active income, this is for you. This is somebody who’s taking a salary and it might be that they are either sole proprietor and it’s all hitting them. It’s a W-2 out of an S corp, W-2 out of a C corp. Is it even if you have a job, like a regular job from somebody else, do you add that compensation or do you just do it off the business that we’re running the plan on?
Jeff: It’s their business.
Toby: It’s their business income. If you’re somebody that has a business, so this is going to be a business owner that is making greater than, is there a magic number?
Jeff: $400,000 worth of income is about the minimum, which equates to about $75,000 in tax liability. If you’re there, that’s the best starting point to start looking at this because anything less than that, you could probably handle the vast majority in a normal 401(k).We pair this with the 401(k) so you can still build both buckets.
Toby: It could be $400,000 or the ability to pay $400,000 because a lot of these people, obviously, like if you’re in an S corp, you may have a million dollars coming down. You’re paying yourself too. You could bump that up to four and start getting some serious benefit.
Chris: Again, we do that strategically. We have an algorithm that determines in that case what is best for them because everybody out there is telling them that hey, you have to put in these high amounts every year for the rest of your time to retirement. It’s not true.
Toby: Yeah, and I’m looking at it. I’m thinking of a few clients, some C corps too, where they’re being gingerly with the payroll because they like that 21% in the corp. You’re like hey, here’s an easy way to get it into a tax deferred vehicle so that you can build up your retirement over the next 10–15 years.
Jeff: Correct.
Toby : Alright, gentlemen. Here’s the easy one. If you guys want to have a talk with Jeff and Chris and see whether or not this makes sense, just type in, retire into the comments and we’ll send you a link. Type in retire into the comments and we will send you a link. If anybody that you think would benefit, please share this and of course, like, and subscribe. Thanks gentlemen for coming.
Chris: Thank you so much for having us.
