Cash Balance Plan Rules & Requirements

A cash balance plan is like a pension, but with a few differences. It’s an employer-sponsored plan like a pension, and it provides employees with the option for a lump sum payment upon retirement or a lifetime annuity.

Each eligible employee has an individual account with the projected lump sum amount that they should receive upon retirement with the option to select lump sum payment (if there are sufficient assets) or a lifetime annuity payment.

All contributions grow tax-free, but like a traditional retirement plan, withdrawals are taxed at the current tax rate.

The Hypothetical Account

Each cash balance plan has a hypothetical account for each eligible employee. The cash balance plan administrator oversees the accounts. The employer pays a ‘pay credit’ which is a percentage of the employee’s salary plus a predetermined interest rate.

The employer sets the interest credit rate. An employer can choose a fixed interest rate or variable. If they choose a variable rate, it’s tied to an index and varies along with the chosen interest rate.

The main difference between a 401K and a cash balance plan is that the interest credit is guaranteed. In a 401K account, the balance is dependent on the investment’s performance which can mean gains and losses throughout the time you have the account.

The Maximum Amount

The maximum amount allowed for cash balance plans varies by year. In 2022, the limit is $3.15 million. The goal of an employer should be to fund accounts to the maximum in 10 to 12 years to meet the maximum limit.

Most cash balance plans are fully funded by the time the owner or employee is 62-years old and the withdrawals can be a lump sum or an annuity payment each year.

In some cases, though, the cash balance plan is in addition to a 401K plan so it may not have as high of a balance.

Employers must meet the funding requirements to qualify for the tax deduction. They are required to make a minimum contribution amount each year and can have an age limit of 21. Some plans can exclude some employees, so it is important to determine which employees are eligible before you start the process.

However, you should remember that a cash balance plan can only be funded if the owner and employees are both eligible. So, if you’re considering a cash balance plan for your business, you should make sure you understand what you’re signing up for.

Can Employers Offer a 401K Plan and a Cash Balance Plan?

Yes, employers can offer multiple retirement account options including a 401K plan with a cash balance plan add-on.

The limits for the 401K versus the cash balance plan vary greatly.

In 2022, the maximum 401K contributions are $20,500 with an additional $6,500 catch-up contribution allowed for employees over 50-years old.

The limits for the cash balance plan are based on the total lump sum limit allowed for withdrawal, which is $3.15 million or $245,000 annuity payments.

Cash Balance Plan Vesting

Cash balance plans can have a vesting period of up to 3 years. This means employers can require 3 years of employment before an employee is vested. At the end of the 3 years, the employee is then 100% vested.

If an employee leaves the company before the 3 years is up, he/she completely forfeits the cash balance plan, and the employer uses the accumulated funds to offset future cash balance account requirements.

Employers aren’t required to instill a 3-year vesting schedule, though. It us up to each employer.

Cash Balance Deadlines

Cash balance contributions by an employer are due by the earlier of the following:

  • Business tax return due date with extensions
  • 8 ½ months after the end of the plan year

Contributions are required annually and typically stay the same unless there are major fluctuations in your annual income and/or the investment performance.

Investing the Assets

As an employer, you can choose where to invest the assets, keeping in mind the typical interest rate credit. Most cash balance plans pay an interest rate credit of 4% – 6%. This means your returns must equal at least that much. If they don’t, you must make up the difference with your contributions.

It’s important to understand that employees don’t have individual investment accounts with a say in where the assets get invested. All funds are in a ‘pooled’ account in the name of the cash balance plan.

The employer funds the account annually to ensure there are enough contributions to meet the hypothetical account balance. The plan advisor manages the investments to ensure the return is at least as much as the interest credit promised to each employee.

Most plan advisors use the following guidelines:

  • Keep a conservative portfolio to prevent large losses from occurring, putting the responsibility on the employer to make up the difference for the promised amounts
  • Don’t overgrow the account so that the balance is higher than the necessary balance for eligible employees

The target return is 5% for most cash balance plan investment accounts.

Terminating the Cash Balance Plan

The cash balance plan is a defined benefit plan which means that it’s permanent. Typically, you cannot terminate the plan unless you have a major change in your business including:

  • Restructuring your business
  • Changes in the law
  • Financial issues
  • Replacement with another benefit plan

Tax Benefits

Business owners reap the tax benefits of a cash balance plan because they make the contributions. The contributions are made pre-tax, and any contributions made for employees (not owners or partners) can be deducted. However, if the company is owned as a corporation, even the contributions for owners and partners can be deducted.

All contributions grow tax-free while they remain in the account. Once withdrawn, they become taxable though.

Final Thoughts

The cash balance plan is an alternative to the defined contribution plans, or it can be used in conjunction with it. The cash balance plan has replaced traditional pension plans in most cases and gives employers a little more leeway when preparing themselves or their employees for retirement.

There are vesting requirements, deadlines, and contribution limits you must abide by along with rules regarding what you must offer your employees once you commit to the cash balance plan.

Paul Sundin

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