The Farm CPA: Cash Balance Plans Can Save Taxes

July 29, 2015 02:40 AM
 
The Farm CPA: Cash Balance Plans Can Save Taxes

Are you a producer five years from retirement facing a $1 million tax bill? If so, using a cash balance plan might eliminate that bill and set you up for a more comfortable retirement. 

Most farmers do a great job of deferring revenues and accelerating expenses during their career. Yet as they approach retirement, it quickly becomes apparent that a huge tax bill might arise from the sudden liquidation of grain or livestock.

Many retire with unsold grain inventories that can easily exceed $1 million and have minimal farm expenses. A retiring sole proprietor farmer can easily face a tax bill in excess of 50%. A retirement plan is one option to help reduce this tax.

Reduce To Retire. The cash balance plan represents a hybrid of two types of retirement plans.

The first is the defined benefit plan, which requires yearly contributions based on the expected payout to retired participants during their lifetime. It requires larger payments as participants get older and closer to retirement. It has a fixed payment during retirement.

The second is the defined contribution plan, which calls for annual contributions that will earn a variable return. Examples include 401(k) plans and profit-sharing plans. Payments during retirement will be based on how well those funds are invested. This plan has a variable monthly payment.

That brings us to the cash balance plan. It has a structure similar to a defined benefit plan—for example, contributions are based on the age of the participants—while allowing for contributions to be based on farm profitability. For instance, a farmer age 60 might be able to deduct more than $200,000 for a period of at least five years. The farmer might pair the cash balance plan with a 401(k) plan to increase the deduction to more than $250,000.

Assess Tax Benefits. Suppose Farmer John just turned 60 and plans to farm for another five to 10 years. He has $1.5 million of unsold grain inventory. 

He sets up a cash balance plan paired with a 401(k) plan, allowing him to deduct $250,000 per year. Over a six-year period, he sells an extra $250,000 of grain inventory each year and offsets it with his cash balance contribution. The extra income will be subject to self-employment tax but no additional income tax.

Farmer John will likely pay more than $750,000 of taxes in his retirement year without the cash balance plan. With cash balance, he eliminates the tax and has more than $1.5 million for retirement. He will owe tax on distributions, but at a much lower rate.

Although defined benefit plans can be costly, a cash balance plan usually costs less than $3,000 to set up with annual maintenance fees of less than $1,500. 

The cash balance plan works extremely well for farmers with no employees and large excess grain inventories. Farms with several older employees might not want to use a cash balance plan since it will require larger contributions for these employees.  

Producers who plan now can eliminate a large future tax bill. Setting up a cash balance plan might be the right answer for you, but don’t wait too long.

Sample Tax Savings With Cash Balance

In the hypothetical scenario below, a 62-year-old producer would realize tax savings of nearly $140,000 with a cash balance plan and a 401(k). Savings are calculated at 50% of the farmer’s tax rate, which includes the top federal rate, state tax and self-employment tax.

  401 (k) Cash Balance Cash Balance and 401 (k)
Contribution $38,000 $238,000 $276,000
Tax Savings @ 50% $19,000 $119,000 $138,000


 

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