Cash Balance Plan for Small Business [Top Strategies + Hazards]


When people think of retirement planning, they usually think first of a 401(k) plan or a SEP. These plans can be great options. But have you ever considered a cash balance plan for small business owners?

Most 401(k) plans have contribution limits that fall far short for many business owners. A cash balance plan should be considered because they have contribution limits that can often exceed $300,000 annually.

However, before we look at the details of the cash balance plan, let’s first examine the two main types of retirement structures: cash balance plans and defined contribution plans.

Cash Balance Plan for Small Business

A cash balance plan aims to provide eligible employees with a specified benefit at retirement. The benefit amount is contributed solely by the employer. It’s a specific amount that considers participants’ salaries and ages. Upon the normal retirement age of 62, the employee can take the money out of the plan and pay tax at the employee’s ordinary tax rate or roll the funds into an IRA.

In contrast, defined-contribution plans (such as 401(k) plans) specify a maximum contribution that can be made by the employee (as a deferral) and the employer. In a defined contribution plan, the benefit amount at retirement depends on the cumulative plan contributions and interest income, and investment gains or losses. 

How do cash balance plans work?

The most popular type of cash balance plan is the cash balance plan. Even though it is a cash balance plan, employee contribution amounts and the account balance feel like a 401(k) plan.

The payout is an account balance compared to a monthly income payment presented in a traditional cash balance plan. For this reason, cash balance plans are often referred to as “hybrid” plans. Like 401(k) plans, cash balance plan distributions are taxed at the taxpayer’s ordinary tax rate upon distribution.

However, cash balance plans allow the employee to take a lump sum benefit equal to the vested account balance. If a retiree or terminated employee desires, a distribution can generally be rolled over into an IRA or to another qualified plan.

But the surprising part is that these plans work great for small owner-only businesses and employers with less than 20 employees. They are a little more complex to set up and administer. So careful planning is imperative when setting up a cash balance plan for small business.

Why are cash balance plans so popular?

They allow the business owner to make substantial tax-deferred retirement contributions. Contribution limits are indexed and adjusted annually based on age. But annual contributions can often exceed $300,000, with $150,000 being the approximate average. This compares very favorably to the yearly limitations of a 401(k) plan.

Let’s take a look at an example. Assume a 56-year-old physician makes $500,000 a year and wants to maximize their retirement contribution. Let’s also assume that the physician has no qualifying full-time employees.

chart with finance, tax and debt, Cash Balance Plan for Small Business

Because of age and earnings, this doctor could contribute up to $230,000 to a cash balance plan in the first year. The doctor can make additional contributions if the cash balance plan is combined with a solo 401(k). Not such a bad deal.

These contributions are fully tax-deductible and can be made up to the date the tax return is filed (including tax extensions). The contributions will grow tax-deferred but will be subject to tax at the presumably lower tax rate in retirement.

Considerations

Due to their low costs and light administrative requirements, defined contribution plans increasingly gain a considerable following. But many organizations still opt to continue providing defined benefit plans. Here are a few things to consider:

Prepare for increased costsCash balance plans have higher fees compared to defined contribution plans. Sponsors should be ready to cover economic costs, benefit costs, administrative fees, Pension Benefit Guaranty Corporation premiums, and investment management expenses.
Plan contributionsSmall businesses should ensure that the business generates enough income to support high contributions under a defined benefit plan. Skipping a contribution increases subsequent contributions and general plan costs.
Plan liabilitiesOpportunities like small-amount bulk-sum sweeps or an ongoing lump-sum offer are effective and cost-efficient ways to help a sponsor reduce liabilities in a cash balance plan.
Investment strategiesA plan investment strategy should align with the plan objectives and acceptable investment returns.
Risk toleranceRisks associated with a plan like equity exposure should be monitored regularly. A limit should be addressed on how much risk a plan can take and an exit strategy if circumstances go out of hand.

Final thoughts

Take a look at the example above. As you will notice, not many retirement structures allow such significant contributions. A 401(k) plan does not even come close.

Cash balance plans are great options for:

  1. Business owners who have consistently high profits.
  2. Professional service companies (physicians, attorneys, consultants, etc.).
  3. Owners who have fallen behind on retirement and are looking to “catch up.”
  4. Owners in high tax brackets looking for tax deferrals. 

If you think a plan may work for you, review your situation with your financial advisor and CPA. Hopefully, a cash balance plan will become a beautiful tool in your retirement arsenal.

Paul Sundin

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