Top 10 Cash Balance Plan Mistakes: How 99% Can ‘Legally’ Avoid

You are probably aware of all the benefits of cash balance plans. They are home runs for high-income business owners in the right scenario.

A cash balance pension plan is your best option if you want tax-deductible contributions in excess of $100,000. The funding levels far exceed the contribution levels for other retirement structures.

However, business owners often just consider the advantages and must remember to address the pitfalls. While you can manage many downsides, you certainly want to be educated. 

This article will address the top 10 mistakes people make when establishing these plans. Hopefully, you won’t make these same mistakes when you set up a plan. 

How Does a Cash Balance Plan Work?

When business owners consider retirement plans, they often choose a SEP IRA or 401(k). These retirement structures are excellent options but come with low contribution levels for many high-income business owners.

For some background, there are two main retirement plan categories: contribution plans and defined benefit plans. A cash balance plan is technically a defined benefit plan, and a 401(k) plan is a defined contribution plan. Defined benefit plans aim to generate a benefit at retirement. In contrast, a defined contribution plan will specify a maximum contribution limit upfront depending on age and income.

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Cash balance plans will provide a benefit of up to $3.4 million. Because of the contribution calculation, the plans do not come with the same annual limits associated with a 401(k) or SEP. As a result, they allow more significant contributions that increase with age and compensation.

As with solo 401(k) plans, cash balance pensions work great for owner-only businesses seeking large tax deductions. But they are more expensive and more complex to administer. The plans must be established by a third-party administrator (TPA) and certified annually by an actuary.

How Do You Calculate a Cash Balance Plan Contribution?

Cash balance plan employee participants will receive annual contributions. Each eligible employee will have a “hypothetical” account balance, much like a 401(k) plan or a profit-sharing account. The TPA and actuary will track employee balances.

Participant accounts grow in two ways:

• A pay credit: This is normally a percentage of pay or a flat dollar amount specified in the plan adoption agreement; and
• An interest credit: This can be a fixed or variable rate that is independent of the plan’s overall investment performance.

Even though your contributions are much higher in a cash balance plan than in a 401(k), the actuary usually provides a contribution range that includes a target, minimum, and maximum. As such, you have some funding flexibility in your yearly contributions.

Hopefully, you understand the basics. Let’s now take a look at our top 10 mistakes and explain how best to structure your plan. Let’s get started.

Top 10 Cash Balance Plan Mistakes

Cash balance plans will have high fee structures compared to defined contribution plans. This is because an actuary certifies the contributions to the IRS. Also, actuaries are highly paid.

These plans do have other issues that complicate the administration process. Since they are technically defined benefit pensions, you are not faced with basic contribution limits. Each year you receive a funding range that is primarily driven by compensation, age, and investment returns. There are just more administrative tasks and responsibilities.

Depending on the plan design and the number of participants, setup fees usually range from $1,500 to $2,500, and administration fees typically run from $2,000 to $4,000. 

Bottom line, if you merely want to contribute $10,000-$40,000 into retirement, stick with a 401(k), SEP IRA, or another type of defined contribution plan. You will only want a cash balance plan if you are looking for annual contributions of $100,000 plus.

When you initially establish a plan, you have some flexibility in year one. Depending on how long your business has been in place and your income and compensation, you can “frontload” the plan and contribute a considerable amount in year one.

One of the ways to accomplish this is to “pull in” W2 compensation (or business profit) from past years. Essentially, the plan states that all eligible participants will get an initial credit for services previously provided to the company. This allows the company to make a year-one funding that covers multiple years.

But be careful. The year one contribution will be high, and the business owner must generally get their W2 higher in subsequent years if they desire similar funding. This upfront funding can then take advantage of the time value of money.

Thanks to IRS changes, you can now set up and fund a cash balance pension before filing your income tax return for the prior year. Many clients set up and fund these plans during the summer or even fall months for the prior year. The goal is to contribute just before the tax return filing deadline, with the latest date being September 15th.

But one issue often arises. With all the advantages of these plans, there can be problems when attempting to combine them with different retirement structures. The IRS combination rules will restrict or limit funding for other retirement plans.

Cash balance plans will typically combine well with 401(k) plans. However, any company profit-sharing contributions will be limited to 6% of W2 compensation (or “deemed” compensation for a sole proprietor). 

Many people fund the maximum 25% profit-sharing contribution for the 401(k) plan and then assume they can layer a cash balance pension plan on top of the 401(k). But the problem is that if you’ve fully funded a 401(k) profit-sharing, your cash balance plan contribution will be substantially reduced, and the economics might not work.

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In addition, many people come to us after fully funding a SEP IRA. SEPs are prevalent retirement structures because the IRS allows them to be opened up and funded just before the tax deadline. But the issue is that they typically don’t combine well with cash balance plans.

SEP IRAs fall into two main categories: (1) model SEPs; and (2) non-model SEPs. Model SEPs are not allowed to be combined with cash balance plans. However, non-model SEPs can be combined. But, unfortunately, they are still limited to the 6% rule noted above.

People come to us after they have fully funded other retirement plans. They usually need help understanding the combination rules. I always tell people that if they want to set up a cash balance plan, they should not fund other retirement plans until they decide on their overall retirement goals.

You probably already know how volatile the stock market has been recently. Unfortunately, cash balance plans don’t like volatility. One of our clients’ biggest mistakes is not understanding the investment options and how their choices can impact plan contributions.

First, plans typically have fixed interest crediting rates (usually around 4-5%). This means that invested assets have an assumed rate of return of 5%. The plan actuary models contribution levels using this specified rate. As a result, the goal is to mirror this interest rate.

Most high-income business owners and physicians desire consistent annual contribution levels that will lower their taxable income. That’s why plan assets should be conservatively invested.

The reason is that significant investment gains and losses can result in funding volatility. This can lead to huge swings in annual contributions. I recommend a conservative investment plan with a mix of stocks, bonds, mutual funds, and other non-volatile assets. Plan assets allocated 100% to stocks are definitely not recommended in a defined benefit plan structure.

If you are looking for more equity exposure, consider increasing your stock allocation in your IRAs, 401(k)s, and other defined contribution plans. With this approach, you can aggressively allocate your IRAs and defined contribution plans with a conservative allocation in your cash balance plan. Overall, you have some flexibility to allocate your investment plans to maximize your portfolio returns while maintaining consistent contributions.

But just because you can manage your investments does not mean you should. If you are uncomfortable managing your plan assets, consider using a financial planner or advisor that understands how these plans work.

Most people want a plan they can fund until retirement age. But some are simply looking for a large contribution for a given year and then want to close the plan.

The IRS is very clear that these plans are meant to be permanent. But you don’t have to have them open forever or for the remaining life of your business. The IRS states that they should be open for at least several years.

But what does “several” mean? It’s not known because the IRS never stated a threshold. But you should set these plans up with permanent intent. It should be something that you’re looking to have indefinitely for your business.

Just because you have long-term intent, you do not need to have the plan open forever. Businesses change and evolve over time. You can close a plan if circumstances dictate and your financial situation changes. Many companies closed their plans as a result of the pandemic. The IRS knows this. But still, you should go into the plan with long-term intent.

You probably know by now that these plans come with mandatory contributions. But this is not 100% accurate because clients often frontload plans (discussed above) by making high year-one contributions. Clients typically take advantage of the time value of money and its relation to tax deductions and investment returns.

If you aggressively fund a plan early on, you might find that you don’t have a mandatory funding requirement in a specific year. You’ll receive a target contribution every year but will also be subject to minimum and maximum funding levels.

Most high-income clients are OK with mandatory contributions. But sometimes, you’ll see situations where business is down. A business might lose a contract, or other unfortunate situations can lead to cash-flow issues. 

I have seen clients not wanting to fund the plan in a given year because they want to build a new home or buy a Ferrari. I had one client whose medical practice even burned down.

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We know that clients can have funding problems. But don’t forget that these plans are permanent in nature. You must ensure adequate funds to cover any required minimum contribution.

You will be subject to an excise tax penalty if you can’t make the minimum contribution. But you can plan in advance before an excise tax is imposed. Also, you have up to the date you file your tax return to fund the plan. Ensure you communicate any funding issues ASAP to your plan TPA.

Communication is imperative in any business relationship. Indeed, some plan administrators could improve client communication. Many specialize in 401(k) plans and have limited background and knowledge of defined benefit plan structures. As such, many TPAs outsource everything to an actuary.

But poor or limited communication works both ways. You will see that clients often need to communicate better with TPAs. Sometimes this is because they don’t fully understand how the plans work.

Over 90% of tax professionals and financial advisors need to learn more about these plans. It is critical to ensure that all parties know how the plan is designed and can communicate freely about the client’s goals.

Many people realize these plans are highly customizable. The aim is to ensure you get the biggest contribution (and tax savings) in the desired year. If you have employees, the goal is usually to limit employee contributions to a minimum. We typically strive to get an allocation of 90% to the owner.

But there are many ways to customize the plans to improve your funding and tailor the plan to your business. Some plan designs and customizations include:

1. Allocating employees a flat dollar amount or percentage of pay depending on the desired outcome.
2. Frontloading the plan, keeping allocations low for a few years, and then opening up a wide funding range.
3. Maximizing owner contributions and limiting participant allocations by only providing participants with a “meaningful benefit.”
4. Using a “tiered” pay credit formula with additional credits for various W2 compensation levels.

When establishing a plan, ensure that you discuss plan specifics with the administrator so you can tailor the plan to your business. Make sure the structure is done right to avoid future problems.

Many clients know that overfunding cash balance plans is a problem. It is. But there are many ways to mitigate the issue and prevent it from happening in the first place.

The IRS maximum is currently $3.4 million. This limit is per individual and per control group. The IRS indexes this amount each year based on inflation, so the maximum will continue to increase.

Accumulating $3.4 million in a plan is tough. But if the plan is invested heavily in risky or speculative investments, you could hit that number well before retirement age.

What happens when a cash balance plan is overfunded? When you terminate and close an overfunded plan, the IRS will assess a 50% excise tax on the overfunded amount. In addition, the entire overfunded balance is subject to what is called “reversion.” This means the whole overfunded balance comes back as income to your business. This could cost you 40%-50% in tax (depending on state tax rates). Essentially, you end up losing the entire overfunded amount.

This sounds pretty harsh. Many clients are concerned about overfunding when a plan is established in the early years. But overfunding is generally not a big issue. You will get funding flexibility in the early years, and then you will tend to build a wide range. But if you fund the plan aggressively and get high asset returns, this can be a problem.

There are plenty of strategies that can help avert or mitigate overfunding issues. If your balance is getting high and your funding range is coming down, ensure you communicate with your administrator.

Thankfully, few people have to worry about reversion and paying excise tax. You can carefully plan to reduce the impact of overfunding.

I mentioned that most CPAs and tax advisors have limited knowledge of these plans. When deciding if a plan is right for you, make sure to work with your CPA to calculate the plan’s state and federal tax impact properly. It would help first to examine your marginal tax rate (the income tax rate each next dollar is taxed). Then reduce your expected taxable income by the desired cash balance plan contribution. This could take you into a lower tax bracket.

Remember state taxes. State tax rates will vary across the country, and eight states don’t have a state income tax. In addition, a couple of states will only give you a deduction for your pension contribution. These states will typically not tax pensions when the money is taken out.

Including the tax deduction on an S-Corporation or C-Corporation tax return is generally straightforward. But it can be more complex for a sole proprietor or partnership.

CPAs often take the tax deduction directly on Schedule C for a solo plan. But this is incorrect. The deduction should actually be taken as an adjustment to income. Schedule C should only reflect employee any contributions.

Ensure your tax professional carefully reviews the plan to educate you on your tax savings. Your business and/or personal tax return should properly reflect the amount to avoid any IRS problems.

Final Thoughts

Carefully consider the pros and cons if you think a cash balance plan can work for you. Proper planning upfront is imperative.

What is our favorite cash balance plan structure? We like to use past service with flexible funding ranges. In addition, conservative index investments work great. 

But most importantly, our favorite plan design mitigates all the mistakes and problems listed above. These plans are powerful retirement tools for high-income business owners and physicians. Hopefully, you won’t make any of these mistakes when establishing your plan.