Most people are familiar with a 401(k). But very few know much about a cash balance plan. In this post, we discuss a basic retirement topic: Cash Balance Plan vs 401(k).
Both of these plans allow tax-deferred contributions and liability protection under ERISA rules. But what is the difference between a 401(k) and a cash balance plan?
These plans both have pros and cons. Let’s take a look at some of the key differences.
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Some background
Let’s start at the beginning. Retirement plans can be broken down into two classes – defined contribution plans and defined benefit plans. A 401(k) is a defined contribution plan and a cash balance plan is a defined benefit plan.
Defined benefit plans essentially look to fund a specified benefit amount at retirement. But defined contribution plans are a little different. These plans specify a maximum funding contribution up front without regard to a future balance.
In a defined benefit plan, the employer guarantees the benefit that the participant is to receive. The employer bears the investment risk. The company has to make sure that sufficient contributions are made to pay the retirement benefit. Accordingly, the company must generally increase contributions to make up for any unexpected investment losses.
A cash balance plan is a type of retirement structure within a class of plans known as Qualified Plans. A 401(k) is also classified as a qualified plan.
What is a cash balance plan?
A cash balance plan allows large annual contributions, with an ultimate goal of over $3 million. The benefit is based on a formula defined in the plan document. This document also contains provisions regarding retirement age and other plan assumptions.
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The plan actuary reviews the funding on an annual basis. The actuary will use assumptions such that they will reasonably fund the benefit at retirement age. In other words, the actuary needs to determine an annual contribution to the plan.
The employer contributes a percentage of the employee’s yearly compensation plus interest charges to a “hypothetical account”. But they do not have an actual separate account for each employee.
Based upon the assumptions and method chosen, there is a minimum funding requirement each year. The traditional qualified defined benefit plan provides a stated monthly benefit at retirement for as long as the participant lives. Also, defined benefit plans must, by law, provide benefits to a participant’s spouse and may provide benefits to other beneficiaries as well.
Many companies combine a cash balance plan with other qualified plans in order to meet their retirement contribution goals. In most situations, an employer will combine a 401(k) Profit Sharing plan in conjunction with a cash balance plan. This will enable the employer to generate sizable retirement contributions for the owner and employees.
Besides the cash balance plan, other examples of traditional defined benefit plans are flat benefit, unit benefit, floor-offset, cash balance and fully insured IRC §412(e)(3) plans. Defined benefit plans can provide benefits other than retirement benefits (for example death or disability benefits) based on objective criteria.
Is a cash balance plan the same as a 401k?
No. They are completely different types of retirement plans. A 401k is a type of defined contribution plan and a cash balance plan is a type of defined benefit plan.
An employer can offer both a cash balance plan and a 401(k) plan as retirement benefits for their employees. This is known as a “cash balance 401(k) hybrid” plan. In a cash balance 401(k) hybrid plan, the employer contributes a fixed amount, or “cash balance,” to an account for each employee, which earns a guaranteed rate of return. The employee’s account balance is portable and can be taken with them if they leave the company.
In addition to the cash balance plan, the employer also offers a 401(k) plan, which allows employees to contribute on a pre-tax or after-tax basis, depending on the plan rules. The 401(k) plan may offer employees various investment options, and the investment earnings are tax-deferred until retirement.
What is a 401(k) plan?
A 401(k) plan is a retirement plan many employers in the U.S. offer. The name “401(k)” comes from the Internal Revenue Code section governing these plans.
Under a 401(k) plan, employees can contribute a portion of their pre-tax salary to the plan up to certain limits set by the IRS each year. The money in the plan is invested, usually in a selection of mutual funds or other investment options chosen by the employer.
One of the main benefits of a 401(k) plan is that contributions are tax-deferred, meaning that employees don’t have to pay taxes on the money they contribute until they withdraw it in retirement. In addition, many employers offer a matching contribution, meaning they will match a portion of the employee’s contributions to the plan.
There are some restrictions and rules around 401(k) plans, such as limits on how much employees can contribute each year when they can withdraw the money without penalty and what happens if they leave their job. It’s important to understand these rules and how they apply to your specific situation if you have a 401(k) plan.
A 401(k) plan has a separate account for each employee who wishes to contribute, where a cash balance plan has one trust account, and a “hypothetical account” for each participant.
Cash balance plan vs 401(k)
Determining which plan is best for you can be complex. But it usually depends on how much you want to contribute to retirement.
If you’re looking to make contributions between $10,000 and $50,000, a 401(k) usually makes the most sense. There is no good reason to go and set up a cash balance plan. A cash balance plan will come with higher costs and complexity. In addition, there’s no need to spend $2,000 annually for administration if you only want a relatively low contribution amount.
But if you’re looking for contributions around $75,000 plus annually, a cash balance plan usually makes the most sense. With plan contributions as high as $300,000, you have a lot of flexibility to make very large contributions. In addition, a couple of thousand dollars a year plan fees are usually not a big issue when you’re making six figure contributions.
But before we jump in, let’s examine some of the important benefits of these plans and point out some key differences between cash balance plans and 401(k) plans.
A 401(k) plan is one of the more common retirement vehicles. A cash balance plan is not so common. The cash balance plan is a type of pension plan that has some similarities a 401k plan. But those similarities can be very subtle.
Many have confused a cash balance plan with a 401(k) plan. But they are very different. In this post, we look at the difference between a 401(k) plan and a cash balance plan. What’s the best plan? Well, it depends.
So let’s start off with the basics. A 401(k) plan is a type of defined contribution plan. Most employees are familiar with these plans. Employers routinely offer these plans nationwide.
The IRS established annually maximum contributions that typically adjust annually. Since the employee is generally contributing their own money, they bear all the investment risk. The plan assets can go up or down. The employee gets all the upside and of course the downside.
What is the difference between a 401(k) and a cash balance plan?
A defined contribution plan maintains an account balance for each participant. This contribution is “owned” by the employee. He or she is entitled to their account balance upon retirement or termination.
Contributions are made to the plan each year and allocated in some nondiscriminatory manner specified in the plan document. Depending on the type of plan, the contributions may or may not be required.
Most often the contribution is discretionary. Other examples of defined contribution plans are profit sharing, money purchase, stock bonus, employee stock ownership, target benefit, 403(b) and 457 plans.
Most profit-sharing plans do not have a required contribution. Employee contributions are allocated to the participant accounts in accordance with the plan document.
What about the benefit allocation?
Generally, each employee contribution is segregated into a “sub account.” The ultimate benefit the participant receives from a defined contribution plan is based entirely on the participant’s account balance. For this reason, the participant bears the risk of investment, since low investment returns will result in a smaller benefit at retirement.
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As stated, the employer does not guarantee the benefits under a defined contribution plan. A defined contribution plan generally favors younger employees. This is because money invested over a long period of time tends to accumulate to large amounts.
The case for the cash balance plan
Remember that deciding to implement a cash balance plan will usually be determined by your desired contribution level. If you want to make contributions below $50,000, then stick with a 401(k) plan. But if you want to make higher contributions, then usually a cash balance plan is your best bet.
Here are some of the main advantages of cash balance plans:
- They offer large, tax-deductible contributions as high as $300,000.
- Cash balance plans are qualified plans and offer tax-deferred growth.
- They can be combined with 401(k) plans to allow for substantially higher contribution levels.
- They do not have specified annual contribution limits like 401(k) plans.
- Plans are age and compensation driven. As such, the older you are and the higher your compensation, the more you can contribute.
The case for the 401(k)
The main advantage to a 401(k) plan is the fact that they are simple to set up and have minimal administration fees. Here are a few reasons why you may want to select a 401(k) plan:
- There are minimal plan set up and administration fees. This, in part, is the result of the need for actuarial review of a cash balance plan annually. However, many 401(k) plans have hidden fees that add to plan administration costs.
- 401(k) plans allow each participant to invest their money as desired. This is contrary to a cash balance plan that has a pooled investment account.
- The plan can be established as a solo plan and then you can add employees later and convert to a safe harbor 401(k) plan.
How to determine which plan is right for you
We’ll answer below some of the basic questions regarding these two plans.
Can you have a cash balance plan and a 401(k)?
Yes, you can. The two plans can be combined to increase the overall contribution amount. Many will include a profit-sharing component with a 401(k) plan and a business can add a cash balance plan too.
In fact, probably 80% to 90% of our cash balance plans have a 401(k) plan as well. Most companies start with a 401(k) when they are first in the market for a retirement plan. Once they desire a larger contribution level they will move up to the cash balance plan. But they keep the current 401(k) plan they have even though they may have a plan amendment. Both plans can really work great together. This is especially true with a solo plan.
Can I have a 401k and a cash balance plan? The table below outlines the pros and cons of cash balance plans:
| Advantages | Disadvantages |
|---|---|
| Tax deferred funding | More expensive to maintain |
| Contributions of $100k plus | Permanent plan structure |
| Tailored plan design | Mandatory contribution requirements |
| Flexible contribution range | No employee deferral |
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The sponsored investment firm manages the investments of this account on a regular basis, investing the funds based on the company’s risk tolerance and investment objectives.
When the employee decides to retire, they have the option to take a lump sum of the contributions, or to receive guaranteed monthly payouts in the form of a life annuity.
You don’t pay taxes on any funds contributed right now, and only pay taxes upon withdrawal of funds as ordinary income.
This makes cash balance plans very attractive to employers with a large number of employees, allowing the employer to deduct a potentially large amount of money contributed to each employee’s cash balance plan.
How to determine which plan is right for you:
- Determine how much you want to contribute. If you are looking to get say $20,000 into a plan then a 401(k) would be your best bet. But if you are looking to contribute over $100,000 then a cash balance plan might be best.
- Consider how consistent your cash flows are in the near future. Remember that solo 401(k) plans are elective, but cash balance plans are permanent. If you look out over the next several years and you expect high profits then a cash balance plan might be the right choice. But if your profits fluctuate widely then you might stick with a 401(k).
- How sensitive are you to the cost of the plan? 401k plans will cost very little to administer. But cash balance plans will cost approximately $2,000 a year to administer. The higher fees are fine if you are making large contributions. So make sure that you consider the cost benefit. What is the difference between a 401k and a cash balance plan?
- Consult your CPA or financial advisor. Do you have a financial advisor or tax professional that you trust? Consult with him or her to see what they think. Your CPA is in a great position to determine the tax impact of any contribution.
- Make your decision before the deadline. Don’t forget. The deadline to set up each plan is December 31st (for a calendar year). Make sure to make a decision before it’s too late.
| Cash Balance Plan | 401(K) |
|---|---|
| Higher plan fees | Low administration costs |
| Does not have employee deferral | Profit sharing allowed |
| Custom plan options | Minimal contribution amounts |
| Permanent plan structure | Allows employee deferrals |
Bottom line
Both cash balance plans and 401(k) plans have many similarities for example in the payout options and the tax benefits. Each have unique benefits for employers who wish to offer them, and for employees who wish to participate.
At the end of the day, if you only want to contribute a rather small amount like $30,000 or so and you want a cheap and easy plan then stick with the 401(k). But if you want to put $100,000 plus into retirement (like most of our clients) then go with the cash balance plan.
I get it. Understanding how cash balance plans work can be challenging. Some may even give up. So take a look at both plan structures and chose a plan that works for you!
