Cash balance plans are complex retirement structures. They are great for the right candidate. But they are certainly not for every business owner.
While these plans offer employers unique tax advantages, you must determine if you’re a good candidate before you spend a lot of time designing the plan. All too often, someone is looking for a specific plan design, but fails to understand they’re a bad fit. In many situations, you can identify a good fit or bad fit upfront.
This article explores ideal candidates for cash balance plans and their benefits. We even have 5 examples and tell you why a plan may or may not work in the specific situation. Let’s jump in.
What is a Cash Balance Plan?
A cash balance plan is a type of retirement plan that is structured as a defined benefit plan. Unlike traditional pension plans, it presents benefits as a specific account balance. Employers contribute to the plan annually and provide guaranteed interest credits on those contributions.
Employees have the option to receive their account balance either as a lump sum or as an annuity. These plans are portable, enabling workers to roll over their funds into an IRA if they change jobs. Cash balance plans also offer significant tax deferral advantages, especially for high-income earners and businesses.
Key Characteristics of Ideal Candidates
High-Income Earners
Cash balance plans offer significant advantages to high-income individuals earning above $250,000. These plans allow them to defer substantial amounts of taxable income each year. The tax benefits help lower their overall tax burden while increasing their retirement savings. Additionally, cash balance plans provide extra savings opportunities for those who are already maxing out their 401(k) contributions.
Business Owners
Small and medium-sized business owners find cash balance plans to be particularly advantageous. These plans enable owners to make significant tax-deductible contributions. Employers can also design contributions to benefit key executives or themselves. Additionally, offering a cash balance plan can help attract and retain talented employees, providing a competitive edge in recruitment.
Professionals Near Retirement
Professionals in their 50s or 60s can use these plans to “catch up” on retirement savings. Doctors, lawyers, and consultants often fall into this category. These individuals typically have high incomes but delayed saving for retirement. Cash balance plans allow them to set aside significant amounts before retiring.
Companies with Stable Cash Flow
Businesses that have predictable cash flow are well-suited for cash balance plans. These plans necessitate fixed annual contributions, making consistency crucial. Companies operating in industries with steady revenues are better positioned to manage these commitments effectively. Stable finances enable employers to fulfill their fiduciary responsibilities without experiencing undue strain.
When a Cash Balance Plan May Not Be a Good Fit
Inconsistent Cash Flow
Businesses with fluctuating revenues may struggle to maintain required contributions. Failing to meet contributions can lead to penalties. For companies with unpredictable finances, alternative retirement plans may be better.
Employee Preferences for Flexibility
Some employees prefer flexible retirement plans like 401(k)s instead of defined benefit plans. Cash balance plans do not offer contribution flexibility for participants, and employees who favor self-directed investment options may not appreciate these plans.
High Employee Turnover
Industries with high turnover rates may find cash balance plans unsuitable. These plans are best for businesses with long-term staff retention. High turnover increases administrative complexity and diminishes plan effectiveness.
Plan Illustrations and Examples
Example #1
- Owner Age = 32
- Business profit = $800,000
- Non-Owner Employees = None
- Industry = Physician
This plan would likely work. The business has a very high profit, and no other eligible employees exist. Because the owner is a physician, he or she should have high, consistent income. With this income, the owner will likely be in the highest tax bracket, leading to a marginal tax rate of 40% to 45%.
The one downside of this plan is the owner’s age. An age of 32 is relatively young. This client will not be able to get as much in compared to someone who is a decade or two older. In addition, because the profit-sharing is limited to 6% with combined cash balance plan and 401(k), the difference between the cash balance plan contribution and the incremental contribution from a 25% profit-sharing will be smaller. But still, considering the high income, this plan would likely make sense.
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Example #2
- Owner Age = 62
- Business profit = $800,000
- Non-Owner Employees = None
- Industry = Attorney
This plan is a home run. The owner could possibly get half of that income into a cash balance plan and 401(k). A $400,000 tax deduction is a great deal!
The attorney has no employees and is a great age. Also, being an attorney in a professional environment will typically lead to more consistent income.
There is little downside to this plan. Remember that these plans have a permanent design, so you want to ensure the attorney has long-term intent. But setting up a plan is a no-brainer as long as the owner has long-term intent.
Example #3
- Owner Age = 38
- Business profit = $200,000
- Non-Owner Employees = 14
- Industry = Auto Body Shop
This plan looks like a no-go immediately. I would likely not even run an illustration for this business owner unless he really wanted to use this plan for fringe benefit purposes. Said differently, if he really wants to reward the employees and does not have a problem giving them a decent contribution, then this plan might make sense.
Let me list out all the reasons why this plan would likely not work:
- The owner is young at age of 38
- Business income for a plan like this is rather low at $200,000. As a result, the owner is in a lower tax bracket, which means the plan’s economics won’t be as favorable to someone in a higher tax bracket.
- With 14 employees, he would likely need to give up around 10% of his employee payroll as a contribution to a cash balance plan and 401(k) plan.
- Because it is a group plan that does not offer professional services, PBGC would need to cover it, which would probably increase the plan fees by $2,000.
- The fact that the income is so low does not give the owner much flexibility to increase his W-2 to make more favorable contributions for him. There is also not a lot of profit left over to contribute for himself and his employees. If his business suffers a slight decline, he won’t have any money to fund the plan.
Example #4
- Owner Age = 58
- Business profit = $500,000
- Non-Owner Employees = 5
- Industry = Dentist
This plan will likely work. The owner is at a very good age and makes a nice profit from the business. He only has five non-owner employees, and you’ll likely be able to exclude one or two of them from the plan.
In addition, as a dentist, this is a professional services plan, so no PBGC is required. The owner has a good enough net profit to fund the contributions and even increase his W-2, if applicable.
Is a Cash Balance or Defined Benefit Plan Right For You?
Owners in their 50s are excellent candidates because they are getting close to retirement and looking to stash away as much money as possible.
Example #5
- Owner Age = 52
- Business profit = $300,000
- Non-Owner Employees = 8
- Industry = Air Conditioning Repair
This plan likely won’t work. While the owner is a good age at 52, most other plan characteristics don’t look great. With eight employees, they have to make employee contributions. Because it is an air conditioning repair business, PBGC is required.
This plan could work if you had an owner with limited retirement who wanted to get as much as possible in. However, they would also need to consider that this plan will be more of a fringe benefit for employees. So you want to make sure that there’s a motivation to contribute for them. Most owners don’t mind contributing to employee for employees, they just want to be able to limit it somehow. I don’t know if limiting it this much in this situation is possible.
Final Thoughts
Cash balance plans are ideal for high-income earners, business owners, and professionals nearing retirement. Companies with stable cash flow also benefit greatly from these plans.
However, they may only suit businesses with consistent finances or high turnover rates. Consulting a financial advisor is key to determining eligibility and maximizing benefits. Individuals and companies can secure a stronger retirement future by aligning financial goals with plan advantages.
