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

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.

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).

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“).

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.

Is a Cash Balance Plan Reported to the IRS?

Cash balance plans have been a favorite retirement structure for many years. But many people wonder if a cash balance plan is reported to the IRS?

This is an important question. While on its face it might not sound that important, people often think these plans can get them audited. They are sometimes very surprised that they can make such a large tax-deductible contribution. We will take a look at four specific ways that the IRS is notified of your cash balance plan.

But the truth is that they’re only tax deferrals. At some point down the road, you’re going to pay tax on the money. So, the IRS is going to get paid, but it’s just going to have to wait a while.

Your third-party administrator isn’t going to directly notify the IRS that your plan is set up. But there will be several ways in which the IRS is notified.

When the administrator gets the EIN

When you set up your plan, you gave the administrator likely a limited power of attorney. This was enabled on form SS-4 them to go directly to the IRS and obtain a tax ID number for the plan. This is also called a plan EIN. 

The administrator submitted an online application for the EIN. They told the IRS the name of the plan, the company that is sponsoring the plan (you), the company address, and also the fact that you were setting up a tax-exempt retirement trust.

So, in theory the IRS is aware of the plan. I’m just not so sure they do a good job of reconciling EINs back to tax returns filed or other information they may have. Remember that if a balance in a cash balance plan (or combined plans) is less than $250,000 they’re not required to file a form 5500-EZ with the IRS. So, the IRS doesn’t really do a good job of reconciling EINs to plan tax returns filed.

Preapproval document

Some people believe that the IRS is notified when the actual cash balance plan is established. This is often the assumption because during the set-up process, they may have received an IRS preapproved plan document letter.

Well, most cash balance plan administrators use a preapproved prototype plan. In essence, this plan has been approved by the IRS as an acceptable template to create a cash balance plan. But the IRS is not approving information input into the form like pay credits, interest credits and other technical aspects of the plan design.

So even though you may have a custom, tailored plan. It is still generated on the IRS approved template. The IRS will typically issue the document provider a preapproval form which is then often distributed to companies they set up plans for.

As such, many companies confuse this IRS approval letter with the actual filing of the cash balance plan document. But this is simply not the case. The TPA and the company are not required to notify the IRS when the cash balance plan is established.

Of course, the company is required to maintain all applicable documents, forms, and supporting documents in case of an audit. So of course, there needs to be an actual legal document. 

On the tax return

When the tax return is filed there is an IRS prescribed category called pensions, profit-sharing and other qualified plans. As such, if there is a number on this line (on the Schedule C, S-corp, Partnership or C Corp tax return) you would assume the IRS is notified.

But this line encompasses a lot of other retirement plans. In fact, most of which are defined contribution plans.

So, the IRS isn’t really able to break out the components of this line and tie it directly to a cash balance plan. Presumably, the higher the deduction is the more likely it is for a defined benefit plan or cash balance plan structure.

When a 5500 is filed

As we’ve stated before, a plan is required to have a 5500 filed each year if it is a group plan. But if it is a solo plan it only needs to be filed if it meets the $250,000 threshold.

Even though you have a plan EIN, it is not actually reported on the form 5500. However, you’re required to report the EIN for the business itself. So the IRS is being told that this specific company has a cash balance plan.

So there you have it. We have outlined 4 specific ways that a cash balance plan is reported to the IRS.

Don’t feel like the IRS is going to audit you because you have set up a plan. The reality is that the plans are a tax deferral and not tax avoidance. The IRS will get it’s tax revenue at some point. They may just have to wait awhile.

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.