More savings, fewer taxes: The powerful tax benefit for business owners

Would you like to pay fewer taxes now and save more for your retirement?¹ If the answer is 'Yes,’ then we have a powerful tax deferral strategy for you to consider. 

At Fisher, we think business owners should reap as much reward as possible for their hard work and success. That’s why this often overlooked approach— we call it the Tax Advantage Layer Cake— opens the door for business owners to turbo-charge personal retirement savings and slash current  taxes at the same time. 

A retirement plan offers owners an enormous tax benefit. The Tax Advantage Layer Cake unlocks all the IRS avenues available for owners to increase retirement savings. What if you could defer up to $485,500 a year? With the right retirement plans in place, the IRS says you can.

How Does The Tax Advantage Layer Cake Work?

This approach to retirement savings is a good fit for high-earning business owners with steady business profits, fewer than about 15 employees per owner, and employees who are younger on average than the owners.  

It combines two retirement plans: a Safe Harbor 401(k) Plan and a Cash Balance Plan. This combination lets business owners maximize retirement savings by deferring both personal income and business profits. 

Ordinarily, tax-deferred retirement plans cannot offer the business owner a greater benefit than what employees can receive. This approach is different, because it maximizes benefit to the owner while also helping employees save for retirement. And it's all permitted by the IRS! 

How Much Can I Save?

That depends on your age and your business profits. Let’s look at some rough numbers. 

For 2024, if you’re age 50 or older, the IRS says you can defer up to $76,500 to your 401(k) from your salary and profit sharing. Besides building pre-tax savings, maximizing your 401(k) deferral also reduces your personal tax bill.

But what if your business has profits? If that’s the case, you’re already painfully aware that you’ll likely be sending a big slice of it to Uncle Sam. 

Fortunately, there’s another way. Imagine each owner could move $250,000 or more out of business profits and directly into retirement savings—pre-tax—in addition to making 401(k) deferrals. Not only could you quickly amass considerable savings for retirement, but you’d also potentially save a ton of taxes today by reducing corporate profits.

Depending on your age, you could be eligible to put away up to $485,500 each year, tax deductible and tax-deferred. See Cash Balance 2024 contributions limits by age here.

Increased Savings, Decreased Taxes

Max Out Your 401(k) Contribution

If you’re like many business owners, you might not be making the most of your 401(k) plan. We know, you’re busy! But we believe maximizing your personal 401(k) contribution is a critical first step in funding the comfortable retirement you want. 

With a regular 401(k) plan, your contribution as a business owner could be limited by the level at which your employees participate in the plan. In contrast, as part of the Tax Advantage Layer Cake, you’ll have a Safe Harbor 401(k), which requires an annual contribution for employees but may result in you avoiding compliance testing.

You build your $76,500 annual maximum (or $69,000 for those under age 50) through a combination of:

• Pre-tax contribution from your salary
• Catch-up contribution if you’re age 50 or older
• Employer match contribution
• Profit sharing contribution

This alone can help you build significant retirement savings. But if you have steady and reliable business profits, you could potentially go well beyond this contribution by adding a Cash Balance Plan to your Safe Harbor 401(k) Plan. This combination can take your savings—and tax reduction—to a whole new level. Discuss how much you can save with your plan administrator and tax adviser.

A Cash Balance Plan Explained 

Remember when most everyone had a pension plan—what the IRS called a defined benefit (DB) plan? DB plans obligated the employer to pay a specific benefit to each eligible employee at retirement. 

Over the years, plan fiduciaries have moved away from establishing defined benefit plans and toward defined contribution (DC) plans—the flagship being the 401(k). Now it’s mostly up to employees to fund their own retirement by contributing to an employer-sponsored DC plan. 

A Cash Balance Plan is a defined benefit (DB) plan with some of the features of a defined contribution (DC)  plan. The employer can guarantee a specific retirement benefit for plan participants with a fixed annual contributions by the employer. 

Why does this matter for business owners? Because DB plans allow much larger contributions—especially for owners—and much larger tax deductions than DC plans. And for business owners, contributions can come straight out of business profits. 

In other words, a pension deduction is the only business expense that an owner can keep, deduct from taxes, and grow tax-deferred. You can move money directly from your business into your cash balance retirement plan, tax-deferred. 

This is the key advantage of line 23 of IRS Form 1120, the U.S. Corporation Income Tax Return. This little line, “Pension, profit-sharing, etc., plans,” lets your business contribute from about $132,000 up to about $441,500 (for 2023, based on your age) into your cash balance plan. See 2024 contributions limits by age here. 

Because this contribution comes from gross income, it can generate substantial tax savings. So in effect, you’re using money you would have otherwise paid In taxes to fund a sizable portion of your retirement savings.

Mind The Rules

Cash balance plans are a bit complex, with some important rules to follow. For instance:

• You’ll need to keep the plan for at least 3 years
• You’ll need to contribute 7% to 9% each year for covered employees
• The plan must be tested against your 401(k) each year
• You’ll need to cover at least 40% of your employees with up to 3-year cliff vesting
• You must guarantee an annual rate of return

As with any investment in securities, there is a risk of loss with this type of plan. Because the employer must guarantee an annual rate of return (typically between 3%-5%), if the plan underperforms the established rate of return,  the plan sponsor must increase contributions to reach full funding status. The catch up contributions can be spread over 7 years however, giving plan sponsors a long time to make up any unexpected shortfalls. For more details on how the annual rate of return works, see our Cash Balance Retirement Guide. 

Cash balance plans are also somewhat more costly than 401(k) plans because you’ll be working with an actuary for administration, plan documents, and filings. But if you’re a good candidate for this approach, your savings—in contributions and in taxes—could greatly outweigh the cost of the plan. 

The added benefits will likely trickle down to your covered employees as well so it is a true win-win. And according to IRS rules, you can build up to about $2.9 million in your account before you are required to stop contributing to the plan. 

How Can I Learn More?

Contact us today! We’re one of America's top registered investment advisory firms with experience In helping business owners set up this sophisticated strategy. We’ll give you all the facts and walk you through the process step-by-step, making it as streamlined as possible.

Specifically, we will partner closely with your CPA and plan designer to:

• Help you dial in on the amount you could save personally, given your specific situation
• Review your employee census to help build a cost-benefit analysis for your Tax Advantage Layer Cake
• Work with you to help structure your employer contributions
• Guide you through the plan installation
• And last but not least, help you finalize your plans and start saving! 

At Fisher, we put your interests first. We specialize solely in small business retirement plans, and we’re here to advocate for you—no kick-backs or commissions.

When you do better, we do better.

Contact us today to get your plan in place for this year. 

¹ Taxes are deferred until time of retirement. It is possible for an individual to pay more taxes in retirement in the event that they are in a higher tax bracket than when they initially deferred the Income. 

Fisher Investments is a registered investment advisory firm and is not a tax adviser. Please consult your tax adviser to determine how much you can save in taxes.