IRS Rules for Cash Balance Plans: 10 Strategies to $1M [+ IRS Pitfalls]

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Cash balance plans just might be our favorite tax strategy. But how much do you know about the cash balance plan IRS rules and requirements?

In this post, we take a look at cash balance plans and examine some of the IRS rules. We will then cover 10 IRS approved strategies to maximize owner contributions. The goal is at least $1 million in retirement in a short period of time. Let’s dive in.

Bending the cash balance plan IRS rules

What if you could boost your retirement savings by over $1 million in the next few years? That’s just what many of our clients have done. They have used a retirement structure known as a cash balance plan.

But getting that much into retirement requires some careful planning. Once you arm yourself with a little knowledge it may not be that tough.

In most situations, owners want to maximize their own contributions and reward a few employees who have been loyal and dedicated. But they may not be too concerned about most employees, especially part-timers or employee groups with high turnover.

So how can an owner maximize his or her contribution? Let’s carefully examine a few strategies.

But beware. Plans should not be established to accrued benefits for a select, small group of employees. The IRS could deem this plan invalid. So make sure that you discuss your situation with a cash balance plan TPA.

#1 – Exclude employees

A cash balance plan does not have to cover all employees. On the contrary, all the IRS requires is that 40% of employees are covered.

The IRS has a 2-part test that must be met under section 401(a)(26). The section mandates that:

  • The lesser of 50 people or 40% of the employees receive benefits under the plan; and
  • The contributions are required to be “meaningful” (more about this shortly).

Because of the age weighted capacity of cash balance plans, you can exclude some of the older employees. This will allow for an overall lower employee contribution and you can still provide a meaningful benefit. Of course, excluding employees is not a problem if you have a solo cash balance plan.

While you can exclude employees younger than 21 and those who worked less than 1,000 hours, the plan must include a minimum of 40% of eligible owners and employees.

#2 – Provide a meaningful benefit

So we just noted that a plan must provide a “meaningful benefit” to qualified employees. Ok, but what does “meaningful” mean?

Well according to the IRS, it means an accrued benefit of at least ½% of pay a year. The IRS does not specify a ½% cash balance credit itself, but a credit that is large enough to generate a ½% retirement benefit. This is a minimum guideline and just one option.

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So the ½% credit translates into approximately 2% to 3% of current pay, depending on salary and age. For example, if an employee makes $40,000 a year, a ½ percent benefit would amount to approximately $800 to $1,200.

The plans allow age weighted contributions. So you can give a larger contribution to older employees and smaller contributions to younger employees. This may make sense if the owner has older employees who have been with the company for many years and would like to reward them for their commitment.

Looking for more information on cash balance plans? Take a look at our ultimate guide to cash balance plans. Discover our favorite strategies!

But remember – a plan will not satisfy the meaningful benefit test if the facts indicate that the plan exists to accrue benefits to a small group of employees. The cash balance plan IRS requirements are strict in this regard.

#3 – Add a 401k with profit sharing

Many owners don’t realize that the IRS rules allow a plan to be combined with other retirement vehicles. Specifically, a majority of plans will include a 401k profit sharing plan.

The advantage here is that the owner can contribute $19,500 as an employee deferral ($26,000 if over the age of 50) and also include a profit sharing component that can get up to 25% into the plan.

Most 401k plans will be set up as safe harbor plans. Safe harbor plans will require a contribution by the employer. Most employer contributions for employee profit sharing will range from 5% to 7.5%.

But the good news is that if the safe harbor plan uses a 3% non-elective contribution with profit sharing, you can subtract safe harbor percentage amount from the 5% to 7.5% range.

See the post on cash balance plan vs 401k if you are trying to understand the differences between the two plans.

#4 – Include spouse

Let’s face it. Most married business owners have spouses who work in the business (at least on a part-time basis). If they provide services to the business, they should be on payroll. Of course, this means IRS employment taxes of 15.3%.

But the advantage of having a spouse on payroll is that, as an employee, they are allowed to receive benefits. This assumes they meet all the other qualifying conditions.

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They would then be allowed to contribute to any 401k with profit sharing as well. This is a simple way to at least have them contribute to the employee deferral and also provide them a benefit under the cash balance plan.

But remember – the spouse has to actually work for the company in order for this strategy to work.

#5 – Part-time employees

One option available to business owners is the ability to limit qualifying employees based on number of hours worked and age.

Cash balance plans allow for the exclusion of employees who work less than 1,000 hours or are younger than age 21. For this reason, an owner could consider employing only young part-timers.

Now this approach may make a lot of sense for the cash balance plan, but may not make a lot of business sense. Young employees may not have the experience level required to run a business. Part-time employees may lack the desired commitment. But at least it is something for the owner to consider.

#6 – Entrance date

The entrance date is the date a plan allows employees to enroll once the service conditions and age requirements are met. Typical entrance dates are monthly, quarterly, semi-annual or annual.

Businesses with substantial employee turnover may desire to keep transient employees off their plan by choosing an annual service requirement. This is the most restrictive timeline that is eligible under the rules.

#7 – Increased wage

In most situations, business owners considering cash balance plans have their businesses structured as S corporations. This makes sense in most cases because it can limit IRS payroll taxes by providing reasonable compensation to the owner and also avoid the double taxation of C corporations.

But the rules allow for contributions to be based, at least in part, on compensation. The owner may desire to increase his or her W-2 wage in order to maximize the plan contribution. The owner could consider this as well for his or her spouse (if applicable).

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But remember that higher compensation means more employment tax. The company will still get to deduct the employer portion of the employment taxes and the owner will get a larger contribution into social security.

In addition, the social security wage base is indexed each year and is $137,700 for 2020. What this means is that the 12.4% tax for social security stops at this wage.

You could theoretically double your wage, which would essentially double the contribution to the cash balance plan. There would only be a minimal increase in employment taxes. This can be truly a win-win scenario.

But make sure that your wage is reasonable. The IRS enforces reasonable compensation on both S corporations and C corporations. Don’t mess with your wage unless you discuss it before with your CPA or tax professional.

#8 – 3 year vesting

Recent IRS tax changes have provided clarification on vesting requirements of cash balance plans. Generally, cash balance plans have more restrictive vesting schedules compared to other types of qualified plans. However, vesting schedules can be favorably structured.

All plan participants are required to be 100% vested after 3 years of plan participation. As a result, most plans are established with 3 year vesting (often called “cliff vesting“).

cash balance plan IRS

What this means is that participants are not vested at all in any plan contributions until they reach the third year of service. At this point, they are 100% vested. If any participant is terminated before the third year of service, all contributions are then forfeited and can be used to reduce future contributions.

#9 – Life insurance

A little-known strategy is that cash balance plans can utilize life insurance strategies for plan participants. A plan is able to use plan assets and any future contributions to pay for the insurance premiums. Under this approach, the plan may have a life insurance policy on plan participants that uses IRS tax deductible dollars.

The life insurance is required to be offered to all plan participants. It may not just be a benefit that is offered to key employees. The cash balance plan rules dictate that the plan itself is the owner of policy and the participant is the insured. Accordingly, make sure you consider whether life insurance strategies will work for you with your plan.

#10 – Overfunding

Because plans are based on actuarial calculations, there are many subjective assumptions. Some of these assumptions will allow flexibility in funding. This can result in over funding in a given year. However, it will result in potentially lower funding levels in future years.

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So, assuming the plan passes actuarial review, the plan may be able to make maximum contributions that will exceed a targeted funding level. This may allow an owner who is having a great financial year to make a larger contribution than anticipated. This can be a great option to lower a tax liability in a given year.

Large IRS Tax DeductionsComplex Plan Structure
Flexible Funding RangeHigh Plan Costs
Creative Plan DesignDiscrimination Testing
Easy Rollover OptionsConservative Investment Returns

Cash balance plan IRS rules

Virtually all employer retirement plans (defined benefit plans or defined contribution plans) must satisfy specific tests to ensure that benefits are not skewed towards owners and/or highly compensated employees (HCEs).

But owners do have a lot of input regarding employee contribution levels. Some business owners want to be very generous to their employees. Other owners, not so much.

Business owners in search of sizable tax deductions and large retirement contributions should consider a cash balance plan. There are certainly some tips and tricks that can be utilized to increase owner contributions.

But make sure you play within the cash balance plan rules. If you don’t, you could get into trouble with the IRS and/or the DOL. If structured correctly, cash balance plans can be a great retirement strategy.

Paul Sundin

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2 thoughts on “IRS Rules for Cash Balance Plans: 10 Strategies to $1M [+ IRS Pitfalls]”

  1. we currently have acash balance plan and because of economic conditions we cannot fully fund it this tax year. Are there requiremnts for this or can we chose to not pay the full amount ?


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