Cash balance plans are becoming more and more popular. But questions still persist over the distribution rules. Specifically, can a cash balance plan be rolled over into an IRA or 401(k)?
In this post, we take a close look at the cash balance plan rollover. We’ll show you how to do it and discuss a few critical steps must be followed.
Table of contents
A little background
You probably are aware that a cash balance plan is technically a defined benefit plan. The company allocates funds, typically a percentage of salary, into an investment account for the benefit of the employee.
Many people are concerned that when they set up a cash balance plan they cannot change or terminate the plan. The IRS contends that these plans are permanent and cannot be terminated at will. There must be a valid reason.
Even though the IRS assumes the plans will carry on indefinitely, it is typically OK to terminate a plan as long as the plan is active for at least a “few years.”
But the regulations are a little vague. They don’t clearly identify what a “few years” truly means. As long as there is a business necessity, the plan can be terminated. Just desiring to get the money to the participant so they can manage their own investments does not qualify as a valid reason.
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A business necessity typically is when the company has lower profits, there is an ownership change, or there is an issue that inhibits the ability to fund the plan on a continual basis. The IRS may also allow the adoption of an alternative plan as a valid reason for termination.
From a practical standpoint, the IRS has typically not questioned a termination that happens more than 10 years after the initial inception. In addition, companies that are terminating a plan that was initiated at least 5 years prior to termination do not generally receive problems from the IRS.
Can a plan be rolled over into an IRA?
So assuming you can terminate the plan, can the cash balance plan be rolled over into an IRA? The law allows you to take money out of the plan in a full lump sum payment or, alternatively, to take that lump sum and roll it into an IRA.
Because the funds in the cash balance plan have not been taxed, you may rollover the funds upon termination into a traditional IRA or a Roth IRA. A traditional IRA is similar to a cash balance plan because the taxes are deferred until retirement. If you roll the funds into a Roth IRA you will be taxed on the entire amount.
In most situations, doing the rollover straight into the IRA makes sense. This is because when you eventually close your business, you won’t have any qualified plans open, and you can consolidate all your old retirement accounts into the IRA.
As such, you won’t have to have multiple brokerage accounts to track each retirement plan. The funds can all be aggregated into one large rollover IRA.
Can I do a Roth IRA rollover?
A Roth IRA functions opposite to a traditional IRA, or, the funds deposited into a Roth IRA must have been taxed already, and no taxes will be required at retirement.
Should you choose to rollover your cash balance plan to a Roth IRA, keep in mind you will need to pay taxes on the amount rolled over, which will be taxed as ordinary income.
People always contact us asking if we can roll the defined benefit plan or cash balance plan directly into a Roth IRA. Many people assume that this is a tax-free transaction and there are no issues with it.
Unfortunately, that’s not the case. Because the Roth IRA is tax-free, you must pay taxes upon the rollover.
In the vast majority of situations, this won’t make much sense. That is unless you have minimal income in a given year and can facilitate the rollover while still staying in a low tax bracket.
However, most of our clients are in large tax brackets, as our average client income is more than $500,000 a year. So even though a Roth IRA rollover might make a lot of sense, tacking the converted income onto your marginal tax bracket will result in too large of a tax burden to make any economic sense.
What about a rollover to a 401(k) plan?
Many people don’t realize that a cash balance plan can be rolled over into a 401k. In fact, you can rollover a cash balance plan into almost any qualified retirement plan. Even though an IRA is the most popular choice, the 401k rollover is a close second.
One of the biggest disadvantages of rolling over a cash balance plan to a 401k plan is that fact that you will have to continue to file form 5500 when the balance exceeds $250,000. This is not the case with an IRA.
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But the 401k plan rollover might still be your best option. This is because you can borrow against the plan an amount up to $50,000 or 50% of the account balance.
|Rollover from 🔶||Acceptable Account 🔶|
|Cash balance plan||IRA|
|Defined benefit plan||401k|
|Cash balance plan||Roth (but taxable)|
A 401k is a great retirement plan because it allows you to save money for retirement while reducing your current taxable income. Contributions to a traditional 401k plan are made with pre-tax dollars, meaning the amount you contribute is deducted from your taxable income. This reduces the taxes you owe for the year and can result in a larger refund. Additionally, the money you save in your 401k grows tax-free until withdrawal at retirement, allowing your savings to grow faster than if you had invested in a taxable account.
Another benefit of a 401k is that many employers offer a matching contribution, essentially free money. Employers may match a percentage of your contributions up to a certain amount. If you contribute enough to receive the full employer match, you are doubling your retirement savings without any additional effort or investment risk.
The employer also matches vests over time, which means that if you stay with your employer for a certain number of years, you will become fully vested and be entitled to keep the full amount of the employer’s contributions. Overall, a 401k is a great retirement plan that offers tax benefits, investment growth potential, and the possibility of receiving free money from your employer.
What is the cash balance plan rollover process?
How do you roll over a cash balance plan into an IRA?
- Determine why the rollover is required
Is it because the employee is leaving and has a vested account balance? Or possibly the plan itself is terminating.
- Locate a custodian who will receive the funds from the rollover
Since the amount will be rolled into an IRA then make sure to open up an account at a provider Vanguard, Schwab or Fidelity to accept the rollover.
- Have the current custodian verify the rollover amount
The current custodian with help from the TPA will determine the final vested balance.
- Process rollover paperwork
The company will have distribution forms that will need to be signed that will instruct the custodian to release the funds. Normally the administrator will facilitate the distribution.
- Verify funds receipt
Unfortunately, this can sometimes take a week or so depending on processing time. Verify that amount equals the vested account balance, net of fees.
Before terminating your plan and rolling it over into an IRA or 401(k), make sure you discuss the issue with a cash balance pension plan administrator.
So can a cash balance plan be rolled over into an IRA? Absolutely. Just make sure that you do your diligence up front so that the plan is properly terminated. Only then can you keep your distance from the IRS.