A looming large income tax liability faces many farmers as they near retirement. They have done a good job of kicking the tax can down the road, but now it may be time to pay the piper (sorry for all of the clichés). There are several tax tools that we can use to reduce this burden and one of them is to use a cash balance pension plan.
There are two general types of pension plans. A defined contribution plan simply contributes money each year based on a percentage of a person's compensation. A typical defined contribution plan includes a profit sharing or 401k plan.
A defined balance plan contributes money based upon the age and earnings history of the employee. This plan is more complicated than a defined contribution plan.
A cash balance plan is a hybrid of each of these plans and is less complicated than a defined benefit plan. As a farmer nears retirement age, the cash balance plan allows the farmer to contribute about 100% of their net earnings into the plan. If they pair it with a 401k plan, they may be able to deduct more than their earnings. This could easily allow a farmer over a five year period to soak up over a $1 million of deferred grain inventory that they are worried about having to pay 40% or more in income taxes on.
As example, assume a farmer expects to have about $1.25 million of grain in his last year of farming and wants to clear that up over a five year period. By reporting $250,000 of net farm income each year for five years, he can then deduct about $1.25 million placed into his cash balance plan. He then will start to take this money out of the plan beginning at age 70 when his tax rate should be much lower.
We recommend that you maintain this plan for at last five years. You are required to cover full-time employees, but their contribution is usually much lower. The fees to set up a plan is usually $2,500 to $5,000 depending on complexity and the annual administration fee is likely around $2,500 or lower.
If you are at least five years away from retirement and want to reduce your tax burden, a cash balance plan may make a lot of sense.