Ask an Advisor: I own a small business that could achieve $500,000 in profits this year. How can I save on taxes?

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Q: I own a small business that could achieve $500,000 in profits this year. How can I save on taxes?

Larry Sprung, CFP®, is a husband, father, entrepreneur, author, and mental health advocate. He founded Mitlin Financial, Inc. in 2004 | Image Credit: Wealthtender.

Congratulations on the success of your small business. I can appreciate wanting to maximize your tax saving and get advise and guidance that won’t land you in trouble with the IRS.

One of the tools business owners should start to understand are cash balance plans are and how they work. These types of plans are becoming increasingly popular among business owners who want to provide both themselves and their employees with a steady stream of income in retirement and provide the business with a significant tax deduction today.

Cash balance plans are a type of defined benefit plan that combines the features of a traditional pension plan with those of a defined contribution plan. Unlike traditional pension plans, cash balance plans provide participants with individual account balances that are more easily understood and managed.

This plan works by having the employer set aside a certain amount of money each year for each participant. This amount is usually based on a percentage of the participant’s salary, and it is credited to the participant’s account with interest. The interest rate is usually based on a fixed rate or a rate tied to an index, such as the 10-year Treasury rate. The account balance grows over time, and the participant is guaranteed a certain benefit at retirement, regardless of the investment performance of the plan.

A big advantage of cash balance plans is that they can provide significant tax benefits for employers. Contributions to cash balance plans are tax-deductible, and the interest earned on the plan’s investments is tax-free.

Additionally, cash balance plans can be used to help business owners save for retirement. Because the contribution limits for cash balance plans are higher than those for other types of retirement plans, business owners can use them to save more for retirement and reduce their tax liability.

This is a real example:

We had a family we work with that has been consistently showing a net profit of $1MM per year. At tax time, this profit is all taxable to the two owners, 50% each. In a circumstance such as this, a cash balance plan can be a powerful tool when used properly. Deferring profit into a cash balance plan allows a business to deduct the deferral as a cash contribution reducing tax liability and taxable profit. This strategy can be a powerful tool when applied effectively.

Some key considerations for a cash balance plan are that they can be more attractive to younger employees who may not be as interested in traditional pension plans which can help employers attract and retain talent.

They also can be more expensive to set up and administer than other types of retirement plans.

Additionally, they may not be appropriate for businesses that have a high turnover rate or that are in industries with a volatile workforce. Lastly, these plans tend to not be as flexible as other plans may be.

It is important to remember that is a difference between tax planning and tax filing.

Make sure to weigh the pros and cons of Cash Balance Plan for your business and consult with a fiduciary advisor to determine what may be right for your company.

The hypothetical investment results are for illustrative purposes only and should not be deemed a representation of past or future results. Actual investment results may be more or less than those shown. Investment advisory services offered through CWM, LLC, an SEC Registered Investment Advisor This article represents the opinion of Mitlin Financial Inc. It should not be construed as providing investment, legal and/or tax advice. Investing involves risk, including possible loss of principal. No strategy assures success or protects against loss. To determine what may be appropriate for you, consult your financial advisor.

This article was originally published on Wealthtender and is intended for informational purposes only and should not be considered financial advice. You should consult a financial professional before making any major financial decisions. Wealthtender earns money from financial professionals, which creates a conflict of interest when these professionals are featured in articles over others. Read the Wealthtender editorial policy and terms of service to learn more. Wealthtender is not a client of these financial services providers.