What is a cash balance plan? More importantly, is it a good fit for you and your business?
Cash balance plans have become very popular. But it’s essential to understand how they work before you set one up.
This post will discuss cash balance plans and the key terms you must understand. I’ll also offer a few tips and tricks along the way. Let’s jump in!
What is a Cash Balance Plan?
A cash balance pension plan is a particular type of IRS-approved defined benefit plan that operates differently than other retirement plans, such as 401(k)s or traditional defined benefit structures.
A cash balance plan specifies the contribution that must be credited to each plan participant and the interest credit to be applied based on those contributions. Each participant has an account resembling a 401(k) plan.
Many refer to cash balance plans as “hybrid plans” because they work like two different plan types combined. More specifically, they offer:
- large, tax-deductible contribution amounts of defined benefit plans; and
- the simplicity of understanding a benefit amount like a defined contribution plan.
Many plans are established for the benefit of the business owner. However, eligible employees must also receive contributions. Plans can be structured to allow large contributions for the business owner and smaller contributions to non-owner employees. Thus, the contributions will meet IRS rules and allow tax deductibility.
When establishing a plan, the company may select the contribution amount for each business owner, up to the maximum IRS amount. The plans are available to every type of business entity and can be customized to allow for funding flexibility. The plan document will outline the rules, which are tailored to the business owner’s requirements.
Watch the video below so you can find out a few more details about how these plans work:
Other Reading: Cash Balance Pension Plans for Dummies: Rules, Benefits + Pension Example
Key Features of Cash Balance Plans
Cash balance plans have some key features that distinguish them from other retirement structures:
- Individual Account Structure. Each participant has a hypothetical individual account, similar to a 401(k). The account grows annually through employer contributions and interest credits.
- Hybrid Nature. Combines design features of both defined benefit and defined contribution plans. Defined benefit in structure but resembles a 401(k) in terms of individual accounts.
- Employer Contributions. The employer makes annual contributions, often called “pay credits.” These typically amount to 5-8% of the employee’s salary or a flat dollar amount.
- Guaranteed Interest Credits. The employer guarantees an annual interest credit, often tied to a benchmark like 30-year Treasury bonds. Interest credit is independent of actual investment performance.
- Higher Contribution Limits. Allow for much higher tax-deferred contributions compared to 401(k) plans, especially for older participants. Maximum account balance of $3.7 million for 2026, adjusted annually for inflation.
- Employer Bears Investment Risk. The employer is responsible for tracking and ensuring the promised benefit is available at retirement, regardless of investment performance.
- Payout Options. Participants can typically choose between an annuity or lump sum distribution at retirement. Lump sums can often be rolled into an IRA or another employer’s plan.
- Federal Insurance. Benefits are typically insured by the Pension Benefit Guaranty Corporation (PBGC).
- Vesting. Full vesting is required after three years of service.
Cash balance plans offer employers a way to provide guaranteed retirement benefits while giving employees more portability and transparency compared to traditional pension plans. They are popular among small businesses and professional practices looking to maximize tax-deferred retirement savings.
Pro Tip: It is not unusual for cash balance plans to allow for contributions as high as $300,000+ in a given year. However, this amount will vary substantially based on the participant’s age and compensation. But it does illustrate the sizable tax deferral advantages to these plans.
How Do Cash Balance Plans Work?
Under a cash balance plan, each participant has a “hypothetical account” maintained by the plan administrator. These accounts are tracked separately from the investment account.
Use EMPARION PLANS on
*Emparion is not affiliated with, endorsed by, or sponsored by these institutions.*
The balance in a hypothetical account in a cash balance plan can be paid out as a lump-sum distribution to a participant in case of death, disability, retirement, or termination of service. Interest and mortality rates prescribed by the IRS determine the value of these hypothetical accounts.
If the assets are insufficient, the employee may be limited to receiving only the annuity form of payment or may have to wait until the assets are enough to take a lump sum. If the recommended contribution is deposited each year, these restrictions rarely occur.
Contribution Levels
The annual contribution limits are determined through complex nondiscrimination testing. Contributions for highly compensated individuals must be reasonably proportional to those made for non-highly compensated individuals.
When conducting the nondiscrimination test, the cash balance contributions are combined with the contributions provided by the company in other retirement plans, typically a 401(k) plan. The required contribution amount is determined based on employee demographics.
After a participant has worked 1,000 hours during a plan year, the employer must make contributions on their behalf and cannot change the plan to reduce the contribution amount. This rule applies even if the participant leaves their job during the year.
By June, most full-time employees will reach 1,000 work hours for a calendar plan year. You can amend a cash balance plan to allow for different contribution levels, but there are some restrictions. Individual participants cannot choose how to invest their accounts. Instead, the trustee, usually the company owner or owners, will combine and invest the plan assets.
Other Reading: Cash Balance Plan Contribution Limit for 2024 [Age + IRS Maximum]
Is a Cash Balance or Defined Benefit Plan Right For You?
Interest Crediting
The cash balance plan participants’ hypothetical accounts will be credited with interest at a rate guaranteed by the plan document, and any excess will reduce future employer contributions if the trust earnings exceed the guaranteed rate.
The participant accounts will increase according to the formula in the plan document. The company contribution will generally differ from the amounts credited to the eligible participants accounts. This difference results from variations between the interest crediting rate and the actual return on the plan’s investments. It can also differ as a result of company overfunding.
More Reading: Cash Balance Plan Interest Crediting Rate: How to Select the Best Rate
What Happens When an Employee is Terminated?
In cash balance plans, when a participant leaves their job, they are entitled to receive the vested portion of the hypothetical account balance.
The plan document determines the participant’s vested percentage. This percentage can be 0% for up to three years of service and 100% after completing three years of service.
Are Cash Balance Plans Insured?
If a cash balance plan includes non-owner employees, it must be insured by the Pension Benefit Guaranty Corporation (PBGC). If your plan is covered by PBGC insurance, you are required to pay annual premiums to the PBGC.
| Pros ✅ | Cons ❌ |
|---|---|
| Tax-deferred contributions | Permanent plan structure |
| Flexible funding range | Complex administration |
| Can be combined with 401(k) | Mandatory contributions |
| Custom plan design | Higher plan fees |
If plan investments underperform or the business owner contributes less than recommended, the plan could have unfunded benefit liabilities, leading to increased premiums.
Other Reading: PBGC: The Complete Guide [Illustration]
How do Tax Deductions Work for Different Business Entities
For each business structure—sole proprietor, S-Corp, and C-Corp—the tax deduction works differently due to differences in how income and taxes are calculated and reported. Here’s a breakdown:
- Sole Proprietor. Contributions to a cash balance plan are made based on the business’s net earnings after deducting expenses, including the contributions themselves. The deductible amount is reported on Schedule C. The contribution also impacts the calculation of self-employment taxes, as it reduces the net earnings.
- S-Corporation. Since S-Corp owners receive income in the form of salary and pass-through distributions, cash balance contributions are typically based on the owner’s W-2 wages. This means that only compensation taken as salary qualifies for contribution calculations, not pass-through income. The cash balance plan contribution is reported as a business expense on the S-Corporation’s tax return (Form 1120-S) and reduces taxable income passed through to the shareholders.
- C-Corporation. Contributions are generally based on the W-2 wages of employees, including owners who draw a salary from the corporation. The deduction for the cash balance plan contribution is taken on Form 1120. This reduces the overall taxable income of the C-Corp.
In all three structures, cash balance plan contributions are deductible in the year they are made, provided they are made by the tax filing deadline, including extensions. The actual deduction limit depends on actuarial calculations, considering factors such as the participant’s age, compensation, and the plan’s design.
Other Reading: Cash Balance Plan Tax Deduction Strategies: Top 5 + IRS Benefit Limit
Key Takeaways
Deciding whether to use a cash balance plan can take time and effort. With numerous options for benefit plan design, it takes time to figure out the best fit for your company.
Hopefully, this guide has provided you with helpful insight into how these plans work. You may find that these plans are your #1 tax and retirement strategy.
