Cash Balance Plan for Self-Employed: Small Business Guide [Video + IRS Tips]


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The self-employed are always looking for tax deductions. One of our favorites is the cash balance plan for small business. The benefits are pretty clear.

However, prior to establishing any plan, make sure that you understand the advantages and disadvantages. These plans can be challenging to understand and it is critical to be educated.

In this article, we will take a closer look at how these plans work. We will also address the following issues:

The tax benefits for small business owners
IRS rules and requirements
How to structure a self-employed plan
Cash balance plan strategies for small business

We also have a video that discusses why these plans work so well for business owner. Let’s jump in!

cash balance plan for small business

What is a self-employed cash balance plan?

A self-employed cash balance plan is actually a defined benefit pension plan. It has a similar structure and design of a traditional defined benefit plan, but with more flexibility. A cash balance plan allows for significant tax deductible funding that can be rolled over into an IRA upon retirement.

When people first think of retirement structures, they typically consider a 401(k) or a SEP. These plans are excellent options, but the allowable contributions are just too low for high income business owners. A cash balance plan can allow contributions as high as $300,000+ annually.

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A cash balance plan simply states that the employer will contribute a percentage of your yearly salary plus an interest credit to an account designated for retirement. The interest credits are usually between 4% and 5%.

In a cash balance plan, your money is set aside into a “hypothetical account” for the named employee.  This account is not the same as an employer’s trust account, but rather is pooled together in one account for all employees with the designated amount for each employee.

What self-employed businesses qualify?

On average, most small business owners will be able to make annual contributions over $100k. These contributions are tax-deductible and grow tax-deferred. These plans will allow significantly higher contributions than a solo 401k or SEP. 

ProsCons
Tax-deferred growthPermanent structure & design
Flexible contribution levelsExpensive to administer
Qualified plan statusConservative investment profile
Front loaded deductionsRequired contributions

Cash balance plans are technically defined benefit plans.  The rules are governed by the requirements and limitations of defined benefit plans. But cash balance plans really function more like a “hybrid” plan (which is their nickname). This means that they are a combination of defined benefit plans and defined contribution plans (401ks for example).

The small business plan for the sole proprietor or S-corp

Under a traditional cash balance plan, the employer will credit a participant’s account balance with a specific percentage of his or her annual compensation. In addition, the account will get an interest credit.

Changes in the actual investment accounts will not impact any final benefits received by the participants. The company itself will bear the ultimate risk of investment returns in the portfolio.

Scrabble pieces spelling TAX

Contributions to cash balance plans are based on actuarial assumptions. This will ensure that the plan will provide adequate benefits to plan participants at retirement age. The actuary must use specific assumptions and calculations to ensure proper contribution levels.

Once the plan is established, the company must continue to make annual contributions until the plan is terminated or frozen. Large companies will set-up plans for long periods. However, many small employers terminate plans during the first 10 years of inception.

If you are setting up a cash balance plan for self-employed, make sure that you do plenty of diligence to make sure that you understand the plan requirements and have the financial ability to fund the plan for an ongoing period of time.

What about the contribution limits?

Like most retirement benefit plans and other individual retirement account plans, there are limits as to how much you can contribute on a yearly basis. For cash balance plans, those limits are not subject to the yearly contribution limit that traditional defined contribution plans abide by.

The yearly contribution limit of a cash balance plan are age dependent, meaning the amount you can contribute depends on how old you are. The reason for this rule is because an older person has fewer years to save, giving them a smaller advantage in the amount that they can contribute.

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The plan document will specify how much that contribution limit is. The plan document includes the contribution formula.

Does a cash balance plan for small business require the same contribution to each employee?  No. The plan has the ability to pay different credits for different groups of employees. As such, the different groups may be defined by things such as age, service, area of operation within the company, and ownership percentage.

Self-employed formula

For each year of participation, the employee accrues a final benefit under the following formula:

(Annual Compensation x Pay Credit) + (Interest Crediting Rate x Account Balance)

= Accrued Benefit

As you can see, interest credits are also added to the cash balance account. The rate of interest credited can vary annually, but the method for determining and allocating it must be specified in the plan document. 

self-employed small business plan

The interest rate allocated can be either fixed or variable. For example, you could use the consumer price index or a government Treasury rate. Sometimes, the interest rate can be connected to the actual plan investment return. However, that can create volatile results when testing the plan and lead to volatile annual contribution requirements.

Typical rates in recent years have been 3% to 5%. As a result of recent changes in the law, there are many interest credit rate options, including utilizing the actual rate of return on plan assets or a fixed amount.

How do pay credits work?

A variety of pay credit rates can be used. Many companies will use a percent of pay. But some will use a flat dollar amount. Either approach is acceptable. Ensure that you review the pay credit formula up front to make sure it meets your goals.

The plan benefits must be definitely determinable and clearly outlined in the plan document. If a small business wants to change the pay credit formula, it can be done but only on a prospective basis.

Common pay credit examples include:

Flat dollar$3,000 for each participant
Percent of pay3%, 4% or 5% of employee salary
Service years$2,000 or $3,000 for each year of service

As a general rule, the pay credit is applied to the current year’s compensation (or salary) at the end of the plan year. Compensation will be defined in the plan document and could either include or exclude bonus or overtime pay.

How do you invest plan assets?

How should plan assets be invested? First, we are not financial advisors and cannot give financial advice. But we can say these funds should be invested rather conservatively.

Self-employed business owners usually want consistent annual contributions to lower taxable income. They want predictable long-term yearly funding.

Our clients have different goals. Most just desire to lower their tax rate thanks to the annual contributions. But some clients are less concerned with reducing taxable income. They just want to build a large retirement nest egg.

Companies wanting to contribute at a consistently high level and who want steady contribution levels should make sure to invest conservatively. As such, the aim would be to match the interest credit rate to reduce funding volatility.

chart with finance, tax and debt

Most fixed-income investments and conservative stock/bond portfolios can meet this goal. The plan actuary can generally keep contributions consistent yearly when asset volatility is reduced. This allows the funding to match the company’s required accrued benefit.

Plan investments can be made into almost any asset class. However, most people will use a balance portfolio of stocks, bonds and mutual funds.

But for employees, the return is specified in the plan document. As such, the employee does not have to rely on a rate of return from the stock market.

Cash balance plan for small business

Does the IRS consider a cash balance plan a “qualified” plan? Yes. A qualified plan indicates that the plan has designated tax benefits. Also, it grows tax free, and contributions aren’t taxed until withdrawal. Most qualified plans include other benefits such as bankruptcy protection and flexible rollover options.

Cash balance plans are based on actuarial calculations with numerous assumptions. These assumptions may allow flexibility in funding a plan, which can be overfunded in a given year. This will lead to lower funding levels in the future. However, a business owner can make significant contributions to reduce taxable income, therefore reducing the tax liability.

Cash plans have a significant advantage over other traditional types of pension plans. Cash balance plans have interest rates; the returns can be predicted more efficiently, giving business owners greater peace of mind.

AdvantagesDisadvantages
Custom Plan Structure & DesignMandatory Contribution Levels
Tax-Deferred Investment GrowthHigher Admin Fees
Possible Contributions > $300,000Permanency Requirement
Self-Directed Assets AllowedComplex Plan Structure & Admin

TPAs and the administration process

The fiduciaries are responsible for overseeing the administration of the plan. The fiduciaries need to understand the legal requirements for retirement plans and monitor compliance. There are some aspects to plan administration, including:

  • Enrolling and covering the right employees.  
  • Selection and monitoring of the administration firm.  
  • Correction of problems.  
  • Handling IRS audits and DOL investigations.  

Is the plan sponsor a member of a controlled group or affiliated service group, requiring that employees of other companies be considered for testing or inclusion in the plan?  

Could there be other workers, such as temporary employees, leased employees, or misclassified independent contractors, who could be entitled to benefits under the plan? Is the plan properly drafted to exclude those workers if they are reclassified as common law employees?  

Just asking the questions is not enough. The factors are fact-intensive, and the analysis is complex. For example, the study of a potential affiliated service group–and its consequences and planning alternatives–requires knowledge of Internal Revenue Code provisions and an understanding of the ownership of the entities and how they work together to provide their services to their customers.

Cash Balance Plan Administration

How does a plan sponsor know to ask the right questions and, once asked, analyze the answers? The failure to do so can disqualify the plan or make a costly correction. To identify and respond to those issues, plan sponsors need help from their advisors.

Plan sponsors face another important coverage issue–how to educate the employees about the plan, the importance of making deferrals into the plan, and the 401(k) investment alternatives.

Without participation by the lower-level employees (or substantial contributions by the employer), the principals of the company sponsor will be limited in their ability to defer, and the value of the plan will be diminished.

What are the tasks?

Who is responsible for ensuring that “excess” amounts are not being contributed? That is, amounts that violate the 415 limits on allocations, the 401(a)(17) limits on compensation, the 402(g) limits on deferrals, and the ADP and ACP limits on deferrals and matches for highly compensated employees? And, if excess amounts are contributed, who decides on the best correction method? How is that decision made?

Who determines employee eligibility? How are plan corrections made?
What are the specific criteria for a hardship withdrawal? What steps must the company take to comply with the qualification rules in approving a hardship request?

A plan sponsor should be able to rely on its administration firm to do most of this work and to provide advice to the employer on the decisions it must make.

Employee participation is a function of thoughtful plan design, good communication, quality investments, and effective face-to-face enrollment meetings. The plan fiduciaries should work with their advisors to ensure the employees are given clear and thorough explanations of the requirements to participate, the importance of deferring, and the basics of investing.

A cash balance plan is a specialized retirement program that allows business owners to set up a tax-efficient savings program for their employees. Cash balance plans generally credit participant accounts each year with the pay credit and interest, depending on the type of investment and employer, which is usually a fixed rate between four and five percent, or an index such as the 30-year treasury bill yield.

The amounts that can be contributed are subject to a complex non-discrimination test. In other words, if a participant’s compensation is more than the average wage of the industry, his or her contributions will be more than four times the amount that employees earn, or less.

Communication practices

Communication is a critical aspect of the whole retirement management process. When choosing a TPA for defined benefit plans, make sure to communicate your requirements, financials, and expectations with the selected candidate or prospects.

Defined benefit plan rules follow a sophisticated reporting, administration, and compliance structure. It’s quite common for employers to be unaware of these intricacies.

It is the responsibility of the TPA to ask the right questions, seek relevant information for filings, and keep involved members in the loop throughout the plan.

Additionally, TPA should maintain proper communication with the employers and employees regarding important contribution deadlines, filings, distribution, or critical plan milestones. Your TPA should work to maximize the financial benefits for you as well as your employees.

You will form a very close relationship with your TPA. They make sure your plan is compliant.

How to structure a cash balance plan for the self-employed

Here are five steps to consider when setting up a cash balance plan:

  1. Run an illustration detailing contribution levels

    The first step is to select an administrator that you believe is qualified and have them run a few illustrations. These illustrations are usually free. So make sure that you consider various funding levels and plan designs. There are many ways to structure these plans and the first step is the illustration.

  2. Consider a 401(k) combo

    Small business owners can combine these plans with 401(k) plans to allow for larger contributions. There are a few restrictions. The restrictions are small compared to the larger contribution levels. But realize that cash balance plans do not combine with SIMPLE IRAs and many SEPs.

  3. Consider prior service adjustment

    In the first year, you have the ability to structure the plan to give a credit for any employee (including yourself) who provided services in prior years. With this approach, you can make a large, front-loaded contribution in year one. This works great if you have higher than normal taxable income in year one. But it will pull contributions from future years, so you should carefully consider.

  4. Run a 5 year projection

    These are permanent plans. As such, you should plan on keeping them for a minimum of 3 years. Our average client has them for approximately seven years. Take a look at your expected funding over a five year period and see if the plan makes sense for you.

  5. Coordinate with your CPA

    The CPA is often the gatekeeper for these plans. They can review illustrations and prepare a tax analysis. Once you know your tax bracket, you can run a sensitivity analysis to determine the tax impact based on different funding levels.

What is the maximum contribution amount?

The maximum amount allowed for cash balance plans varies by year. In 2023, the limit is $3.4 million. An employer’s goal should be to fund the plan for 10 to 12 years to meet the maximum limit.

Most cash balance plans are fully funded when the owner or employee is 62 years old, and the withdrawals can be a lump sum or rolled over into an IRA. In most cases, though, the cash balance plan for self-employed is in addition to a 401(k) plan with an employee deferral.

Employers must meet the minimum funding requirement to qualify for the tax deduction. They must make a minimum contribution amount each year with a minimum age of 21. Most plans will exclude some employees, so it is essential 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 eligible. So, if you’re considering a cash balance plan for your company, you should ensure you understand what you’re signing up for.

Tax benefits for small business

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, even the contributions for owners and partners can be deducted if the company is owned as a corporation.
All contributions grow tax-free while they remain in the account. Once withdrawn, they become taxable.

As a general rule, plan contributions are applied to the year they are made. However, you can apply them to the prior tax year if all of the following requirements are met:

  1. The contributions are made by the due date of your income tax return for the prior year (plus any applicable extensions);
  2. The plan document was established by the end of the prior year; and
  3. As a policy, the plan treats the contributions as if they were received on the last day of the prior year.

In addition to the above requirements, you must do either of the following: (1) provide a written statement to the plan administrator or the trustee that the contribution will apply to the prior year; or (2) Deduct the contributions on the applicable income tax return for the prior year.

Final thoughts

The above strategies can achieve maximum owner contributions, but IRS rules must be followed. If properly structured, a cash balance plan is an excellent retirement strategy.

The important point to note is that self-employed people have plenty of retirement options. Just do your research and choose the best plan for you.

Paul Sundin

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