401(k) Plus Cash Balance Plan: The Little-Known Structure [+ Pitfalls]

Have you heard of a 401(k) Plus cash balance plan retirement structure? This specific “combo” strategy is used by over 90% of our clients.

A cash balance plan is a defined benefit plan but heavily resembles a defined contribution plan with hypothetical individual employee accounts. An employee’s account earns a pay credit, normally 5% of their salary each year, plus an interest credit, at a fixed rate or variable rate on your account balance.

An investment manager does the investing for the beneficiaries, and a statement is sent to the beneficiaries with the hypothetical value of the account they are eligible to receive at retirement. 401(k) plan, on the other hand, is a qualified employer-sponsored retirement plan that allows eligible employees to make salary-deferral contributions on a post-tax and/or pretax basis.

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What is a 401(k)?

General Requirements:

  • Used for a company with no employees. The spouse of the business owner can be included in the plan
  • Two types of contributions – salary deferral and profit sharing
  • Maximum tax-free contribution noted in the table below
  • Easy to set up. Filing Form 5500-SF is not required until plan assets reach $250,000
  • If employees are hired in the future who qualify for a 401(k) plan, contribution levels and filing requirements can change..
  • Must be formally elected before December 31, but contribution can be made by the tax filing date of April 15, or October 15 if an extension is filed
  • Can be combined with other plans, such as IRA or defined benefit plan. There are salary deferral limits per individual, but profit sharing and a defined benefit plan can further increase amounts to be contributed to retirement savings.

Here are the current 401(k) contribution limits:

401k Contribution Limit for 2024Amount
Deferral for under age 50$23,000
Deferral for age 50+$30,500
Maximum for under age 50$69,000
Maximum for age 50+$76,500

If you operate your business as a sole proprietor, partnership or corporation with no employees, you can choose to open a one-participant 401(k). This is a great way to save money towards retirement with significant tax advantages.

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Contributions are based on two types. The business owner should think of themselves as both an employee and an employer when making the contributions.

Cash Balance401(K)
Higher compliance costsMinimal plan fees
No employee deferralProfit-sharing option
Custom designLower funding amounts
Permanent plan requirementEmployee deferral allowed

One-participant 401(k)s have few disadvantages. There is not much paperwork that needs to be filed, and Form 5500-SF is not required until plan assets reach $250,000. However, it is important to note that if employees are ever hired who meet plan eligibility requirements, a 401(k) plan must be offered to them and the plan must be changed for tax purposes. This will affect annual contribution limits and tax-filing requirements.

What is a Cash Balance Plan?

In a cash balance plan, the employer makes annual contributions to an employee’s account, typically expressed as a percentage of the employee’s salary. The employer guarantees a minimum rate of return on the account balance, which is generally tied to a specific benchmark, such as the 30-year Treasury bond rate. The account balance grows over time as contributions and interest are added to the account.

At retirement, the employee is entitled to the balance in their account. The employee may choose to receive the balance as a lump sum or as a lifetime annuity, which provides a monthly income stream for the employee’s lifetime. The annuity amount is calculated based on the employee’s account balance and actuarial assumptions such as the employee’s life expectancy and interest rates.

401k Plus Cash Balance Plan
401k Plus Cash Balance Plan

Cash balance plans are similar to traditional defined benefit plans in that they are funded by the employer and provide a guaranteed retirement benefit. However, cash balance plans differ from traditional defined benefit plans in several important ways.

In a traditional defined benefit plan, the retirement benefit is calculated based on the employee’s years of service and average salary. The employer is responsible for ensuring the plan has enough assets to pay for the promised benefits, which can be a significant financial burden.

401(k) Plus Cash Balance Plan

The IRS publishes contribution limits for all defined contribution retirement accounts. However, you have a chance to exceed this limit by having a cash balance plan combined with your 401(k). The contributions to a 401(k) cash balance plan are based on a set interest rate tied to the U.S. 30-year Treasury bond rate and a percentage of salary.

These contributions are put into an account and saved for a participant’s retirement, but plan rules must be followed.

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Benefits of the combined plans

  1. Higher Contributions – 401(k) cash balance plan allows for a higher contribution towards retirement. The more the contribution, the more retirement benefit will be.
  2. Almost Guaranteed Rate of Return – The contributions towards the plan is made by the employer or the company you own based on a set interest rate and a percentage of your salary, account balance will grow without much of your involvement.
  3. No Involvement – 401(k) cash balance plan is managed by an investment management company, all decisions are made by them and the employer does the contributions.
  4. Portability – In case one leaves the company, they can take the 401(k) cash balance plan to another pension plan or roll it to an IRA.
  5. Partially insured by the Pension Benefit Guarantee Corporation – Pension Benefit Guarantee Corporation underwrites a portion of the account. This prevents the risk of losing full amount in the account.
  6. Tax Advantages – Employers enjoy tax deductions and deferral from the contributions towards a 401(k) cash balance plan for their employees.

Disadvantages of the plan combo

  1. Only benefits business owners and key employees – All companies do not enjoy the 401(k) cash balance plans. Limitations that hinder cash balance plans, like consistent profitability also affects 401(k) cash balance plan. Those with high compensations like business owners and key employees are the ones who can gain the most from 401(k) cash balance plan.
  2. Extra Approvals Required – IRS will need a company to meet some requirements before setting up a 401(k) cash balance plan.

How to set up a combo plan?

  1. Run an illustration

    Make sure to get an illustration that shows you how much you can contribute to a 401(k) and how much to a cash balance plan.

  2. Identify the profit sharing limitation

    When doing a combo plan, the profit sharing is limited to 6%. Make sure that your illustration is adjusted accordingly.

  3. Establish the plans before the deadline

    Both plans must be established by Dec 31st to be effective for the current. The good news is that you can fund them up to the date the taxes are filed (including extensions).

  4. Determine if a safe harbor 401k is needed

    If you have employees who work over 1,000 hours a year and are at least 21 years of age then you will likely want a safe harbor plan.

  5. Fund the plan

    The good news is that you can fund the plan in the subsequent year as long as funding occurs before the tax return is filed (including extensions). This is a nice benefit.

Conclusion

401(k) plus cash balance plans have several advantages as compared to solo 401(k) or just cash balance plans. An individual can maximize privileges provided by both plans and save more towards their retirement.

Consult and do research before trying to adopt this plan in your company, you may need an actuary to certify that the company can generate enough income to make the increased contributions.

Paul Sundin

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