“Please, Sir, I Want Some More”

Oliver Twist had no luck with his plaintive request, “Please, sir, I want some more.” But high-income doctors, lawyers, accountants and small-business owners in the US can get more—increased tax deferrals for retirement savings—courtesy of a cash balance plan.

Recent US tax rate increases have made it harder to save for retirement, just when below-average expected returns and increased longevity have underscored the need to do so. Many professionals and small-business owners deal with this issue by maxing out their defined-contribution plans, such as 401(k) and profit-sharing plans. But such plans have limits on their contributions, and some investors have both the ability and desire to save more.

Enter cash balance plans, which offer predetermined annual benefits in combination with individual account balances.* That makes these plans hybrids—part defined-benefit and part defined-contribution. The maximum annual contributions to these plans far exceed the maximum for defined-contribution plans, and they tend to be excellent vehicles for firms such as professional practices and small businesses, where the ratio of staff to owners is less than 10 to one.

The display immediately below shows that a 55-year-old, for example, can contribute up to $56,500 into a 401(k) and profit-sharing plan combined, but as much as $147,000 in a cash balance plan.

The Tax Deferral Power of Cash Balance Plans

From age 50 to 65, someone who contributes the maximum to both a 401(k) and profit-sharing plan would be able to defer $904,000 of income ($56,500 per year)—a tidy sum, but one dwarfed by the extra $2.7 million allowed with a cash balance plan.

The advantages of deferring taxation can be eye-opening, since the investments may compound tax-free for many years. Consider the example in the next display, which compares two strategies: investing that $904,000 in a taxable account over the 16-year period (roughly $500,000 after paying income taxes each year at a blended federal and state rate of 45%), then letting the proceeds grow for another 20 years in a taxable account, versus deferring taxes on the funds for the full 36-year period (accounting for required minimum distributions). In both cases, we assume the funds are liquidated and that taxes are paid at age 85. (This is not an optimal strategy, but it allows us to quantify the value of tax deferral at a particular point in time.)

To Defer or Not to Defer: That Is the Question The tax deferral provides an impressive benefit. In both scenarios, we assume a bond-tilted allocation and, based on our assumptions about asset growth, inflation and tax rates, we estimate that in median markets the investor would wind up with $2.2 million in the taxable account by age 85. Again, that’s a tidy sum—but the investor would accumulate $3.4 million if she took advantage of tax deferral. That’s 55% more real after-tax wealth—as close to a free lunch as you can get in investing.

All of this is without considering the potential benefit of the extra tax deferral available from a cash balance plan. And our projections assume that the investor’s taxes remain at the highest marginal bracket, although in fact taxable income declines for many retirees.

Groups considering a cash balance plan should consult with experienced actuarial, tax and legal professionals. Our research suggests that the best results come if the plan is designed to fit with each participant’s retirement and overall wealth objectives.

*Participants’ accounts are “notional,” or hypothetical, since the plan holds the funds in aggregate. However, the money in a notional account belongs to the participant upon leaving the plan, and can be rolled into an IRA.

This article should not be considered advice for creating a plan. The rules and regulations regarding tax-deferred plans are extensive and can be complex. This publication is not intended to provide actuarial, tax or legal advice. Anyone considering a cash balance plan should consult with experienced actuarial, tax and legal advisors.

Note on Wealth Forecasting: The Bernstein Wealth Forecasting System SM , driven by the Capital Markets Engine, uses a Monte Carlo model that simulates 10,000 plausible paths of return for each asset class and inflation, and produces a probability distribution of outcomes. The model does not draw randomly from a set of historical returns to produce estimates for the future. Instead, the forecasts (1) are based on the building blocks of returns, such as inflation, yields, yield spreads, stock earnings and price multiples; (2) incorporate linkages that exist among the returns of various asset classes; (3) take into account prevailing market conditions at the beginning of the analysis; and (4) factor in a reasonable degree of randomness and unpredictability.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Kathleen M. Fisher

Head, Wealth and Investment Planning Group; National Managing Director
Kathleen M. Fisher was appointed Head of the Wealth and Investment Planning Group in 2014. In this role, she leads the team responsible for developing and communicating asset allocation advice and investment strategies for Bernstein’s high-net-worth clients. Since 2013, she has also overseen research on investment planning and wealth transfer issues facing high-net-worth families as well as endowments and foundations. Fisher joined the firm in 2001 as a Senior Portfolio Manager and member of Bernstein’s Private Client Investment Policy Group; she was appointed a National Managing Director in 2009. Before joining Bernstein, she spent 15 years at J.P. Morgan, most recently as a managing director advising banks on acquisitions, divestitures and financing techniques. Earlier in her career, she was an equity analyst at Morgan Stanley, covering bank stocks, and an economic research analyst at the Federal Reserve Bank of New York. Fisher graduated Phi Beta Kappa from Bates College with a BA in economics, magna cum laude, and earned an MBA in finance from New York University. She is a former trustee of Bates College and currently serves on the boards of Southwestern Vermont Health Care and of Hildene—The Lincoln Family Home.

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