Cash Balance Plan Pros and Cons [Video + Table]


Understanding the cash balance plan pros and cons can be challenging. Many people are aware of the advantages of these plans, but how much do you know about the disadvantages?

These plans are often misunderstood. As such, when I discuss them with clients I try to make it very clear what the downsides are.

In this post, I will provide a detailed review of the advantages and disadvantages. There is also a nice table at the end of this post. Let’s get started!

A close look at the advantages

Many people see the advantages of cash balance plans and dive in. But don’t be too quick. You should carefully analyze the pros and cons and make sure you are educated. Let’s take a look at the advantages and give you a detailed review.

Large Contributions

This advantage is clear cut. A cash balance plan allows you to contribute a much higher amount than other retirement vehicles.

The plans don’t really have annual contribution limits like 401(k) plans. The goal is to have a large, specified amount at retirement (usually age 62). As such, annual contributions can be as in excess of $300,000, subject to age and income.

Bottom line: if you want get $100,000 annually into retirement then this is usually your best option. A 401(k) plan will not even come close.

Funding Flexibility: Remember you have a range

Many people think that plan contributions are fixed. While these plans can be structured as fixed contributions, most plans allow for more flexible funding.

In reality, you are given a range. The range will represent minimum and maximum funding amounts. Typically, there is a targeted funding amount that is usually somewhere in the middle.

This range gives you some flexibility to make larger contributions in a year with high profits and lower contributions in down years.

Get a FREE IllustratioN!

Just give us a little information and we’ll get you a custom illustration in 24 hours.

So in reality, you have more funding flexibility that you might think. In addition, with each year of service the range tends to widen. This can make it very easy to get the contribution you desire while staying in compliance.

Combining Plans: Nice way to turbo charge

Not only are you able to contribute more to a cash balance plan, you can also combine them with 401(k) plans. When you combine the plans together you can turbo charge your contribution. But there is one limitation.

401(k) plans (with profit sharing contributions) will limit any profit sharing to 25% of compensation. This does not impact the employee deferral.

Cash Balance Plan Pros and Cons

But when a 401(k) plan is combined with a cash balance plan, the company is restricted to a 6% profit sharing contribution. Usually this is not much of a problem because the cash balance contribution is so large it makes up for the smaller profit sharing amount.

In fact, combining plans is so popular I would guess that 90% of the plans we do are combos. They just allow you to get larger contributions for minimal additional cost.

Tax Deductible: The #1 tax strategy

Did I mention that the contributions are tax deductible? These plans are “qualified” plans just like 401(k)s. What this means is the contributions going into the plan are tax deductible and then are taxed once withdrawn.

Get a FREE IllustratioN!

Just give us a little information and we’ll get you a custom illustration in 24 hours.

However, the funds can be rolled over into a 401(k) plan or into an IRA to avoid taxation. This is the most selected option.

Make sure you discuss your marginal tax bracket with your CPA. The higher the rate the more these plans make sense. There is a reason why many of our new plans come from states like California and New York.

Age-Weighted Contributions: The older the better

The contributions under these plans is age-weighted. This is a huge benefit for most business owners, but will make them more challenging for younger folks.

The older we get the more money we make and the more focused on retirement planning we get. This makes sense. When we are younger we see ourselves living forever and we usually don’t have much money to contribute to retirement anyway.

Our average client is probably around 50 years old with income of $400,000 plus. At this age, retirement planning is almost as important as tax deferral strategies.

Most plans are set up with a retirement age of 62. Since the plans are aiming for a retirement balance at age 62, the older we get the closer to that age we become. This is why contributions are much higher for 60 year olds compared to 30 years olds.

A close look at the disadvantages

So by now you understand the advantages and why these can be great tax and retirement structures. But what about the downside? Is there a catch?

Well yes…sort of. No pros and cons analysis is complete without a detailed review og the downside. Bottom line: they are best suited for business owners with consistently high income who are 40 years of age plus.

Conservative Investments: Not as bad as you might have thought

Many people believe that cash balance plans should be invested in conservative assets. They think that they are supposed to sacrifice nice returns for a safe retirement plan.

Well this isn’t actually correct. It is true that plans have a stated interest rate credit, which is normally around 5%. So in theory the plan should aim for investment returns that will mimic this stated crediting rate.

Book a FREE 30 Minute Call!

Schedule a FREE call and we’ll show you how we structure plans for maximum tax efficiency.

All things being equal, higher returns can lead to lower future funding and lower returns will result in high future funding. So the real goal is to limit volatility. This helpful when examining the cash balance plan pros and cons.

I tell clients who want to make more risky and speculative investments to do it in their 401(k) plans. It’s because 401(k)s establish a funding amount upfront. Once the money goes into the plan, the investment returns do not impact the plan.

Higher Pension Plan Cost: Make sure to check around

401(k) plans are relatively inexpensive. They can be free from some providers and custodians, or can run a few hundred dollars when there is a 5500 filing required.

There is no doubt that these plans are more expensive than 401(k) plans. But when you compare the cost to the benefits, I certainly believe these plans can be a bargain for the right business.

We set up these plans for solo business owners for only $990. Annual administration will cost you around $2,000. So the higher cost is evident.

But with the average plan contribution around $150,000 and marginal tax rates of approximately 40%, it doesn’t take much for the plan costs to be justified.

But don’t set these plans up if you only want to do make a contribution of $20,000 or $30,000. Stick with a 401(k) plan. That is of course unless your tax bracket is so high that you want to ring out all the tax savings you can.

Permanency: A problem for some

Yes permanency can be an issue. But does permanent mean forever?

Well the IRS says that permanent is not forever. They say the plan should be open for at least a “few years.”

There is no doubt that these plans should not be start and stop. You should plan on having them as an ongoing part of your business. But if you have the plan open for a few years and then terminate it, you should not have a problem with the IRS as long as you acted in good faith.

There is no doubt that you will see many plans being terminated as a result of Covid. But remember that you don’t have to shut down your plan just because your income is down. You can amend the plan to lower the interest crediting rate or change the formula. You have options.

Non-Elective Contributions

One of the biggest advantages of 401(k) plans is that they are elective. If you have a down year you opt to not contribute. You can max fund in a good year. The point is that the contributions are elective and are not mandatory.

But cash balance plan contributions are not as simple. Unless a plan is overfunded, you will have to make a contribution annually.

Even though you have a funding range, you must at least make the minimum contribution or you will be faced with an excise tax.

Get a FREE IllustratioN!

Just give us a little information and we’ll get you a custom illustration in 24 hours.

These mandatory contributions scare a lot of business owners. But in reality, they usually aren’t that bad. Many businesses have funds in their bank account that was earned in prior years.

In addition, remember that you have up to the date you file your tax return (including tax extensions) in order to make the contribution. So even though your profits may be down slightly now, you may have the cash to make your contribution next year. Minimum funding is usually not a deal breaker.

More Complexity: This is a given

You don’t get something for nothing. The large tax deductible contributions come at a cost – an emotional cost. These plans give some folks headaches.

These plans are complex and require careful coordination with your third-party administrator, CPA and financial advisor. In fact, many advisors and accountants don’t understand the plans. This makes your situation even more daunting.

So you need to accept that your financial situation has created some additional work for you. But if you can get through the first year, you should be fine.

Cash Balance Plan Pros and Cons

The five steps to examining the cash balance plan pros and cons:

  1. Determine if the plan should be combined with other retirement structures

    Cash balance plans can be used alongside other retirement structures, such as a 401(k). Probably 90% of our plans are combined with another retirement plan. This allows clients to not only maximize funding in high income years, but also provide funding flexibility in down years.

  2. Don’t forget the plan costs compared to other traditional options

    Cash balance plans will have higher fees associated with set up and maintenance. In most situations, these fees are justified when you are contributing $100k plus. But they don’t make a lot of sense if you are only looking to fund $30k or so. Ensure that you look at your estimated funding over the next 5 years to see if the cost/benefit makes sense.

  3. Analyze how much you can reliably contribute

    The largest benefit of these plans include the high contribution limits, as well as “catch-up” contribution options. The options include prior service funding that will allow the plan to be front loaded. This allows for large contributions in year one. But it can only be used in the first year of funding. No cash balance plan pros and cons analysis is complete without examining funding levels.

  4. Make sure you discuss with your financial professionals

    Your financial advisor and CPA know the most about your situation and can usually point you towards the best plan. But we find that many advisors don’t understand these plans as much as they should. Fortunately, they are a good starting point for many small business owners.

  5. Determine if you can timely fund

    The IRS sets firm guidelines for the timing of plan contributions. Because of the large funding requirements, make sure you can make the payment before you file your tax return. This initially might sound easy, but can require some careful planning.

ProsCons
Significant tax deductionsComplex structure requirements
Range for min/max contributionsPermanent plan design
Asset protectionMandatory funding
Investment gains tax-deferredHigh cost structure

Summary

When it comes to retirement accounts, the goal is to incentivize people to save for retirement, while at the same time restricting them from taking advantage of certain loopholes.

Hopefully, you have had a chance to weight the cash balance plan pros and cons so you can make the best decision. This will help you determine if a plan is right for your situation!

5/5 (1 Review)
Paul Sundin

Get a FREE 30 Minute Consultation

Reach out to us today and we'll show you our favorite strategies! We can show you how to structure a plan for maximum tax benefit and provide you with a custom plan design.

Leave a Comment