Cash Balance Plan vs SEP IRA: A Simple Comparison [+ Illustration]

We know that business owners enjoy saving money on taxes. What better way to begin than with a retirement plan? In this article, we look at the Cash Balance Plan vs SEP IRA.

The good news is that you have plenty of options as a business owner when you’re looking for retirement structures. You can start with a simple plan like a SEP IRA. You can then graduate to a more complex plan like a cash balance plan.

Which retirement structure is best for you? It depends, of course. This post will review your options and compare a cash balance plan to a SEP IRA. Let’s jump in!

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What is a cash balance plan?

A cash balance plan is a defined benefit retirement plan that is becoming increasingly popular among employers as an alternative to traditional pension plans. In a cash balance plan, the employer sets aside a certain amount of money for each employee, usually based on a percentage of their salary. The plan guarantees a specified retirement benefit to the employee based on accumulated contributions and a predetermined interest rate.

Unlike traditional pension plans, cash balance plans have a more predictable benefit structure, as the retirement benefit is based on a stated account balance rather than on years of service or final average pay. This can make it easier for employees to understand and plan for their retirement income.

Cash balance plans also offer portability, as employees can take their accrued benefits with them if they leave the employer before retirement. In addition, cash balance plans are insured by the Pension Benefit Guaranty Corporation (PBGC), which provides some level of protection if the employer cannot meet its obligations under the plan.

Cash balance plans offer employers a way to provide their employees with a defined benefit retirement plan that is simpler and more predictable than traditional pension plans while still providing attractive employee benefits.

What is a SEP IRA?

A SEP IRA, or Simplified Employee Pension Individual Retirement Account, is a specific type of retirement savings plan to allow small business owners and self-employed individuals to contribute to a tax-advantaged retirement account for themselves and their employees.

Cash Balance Plan vs SEP IRA

With a SEP IRA, the employer contributes to a traditional IRA account for each eligible employee, up to a certain percentage of their compensation or a maximum dollar amount (whichever is less). The company is not required to make contributions yearly, but if they do, they must contribute the same percentage or dollar amount for all eligible employees.

Contributions to a SEP IRA are tax-deductible for the employer, and the investment earnings grow tax-deferred until withdrawals are made in retirement. Employees do not pay taxes on SEP IRA contributions until they withdraw the money in retirement, which is taxed as ordinary income.

Cash Balance PlanSEP IRA
Mandatory ContributionsElective (Optional) Contributions
Contributions as High as $400,000Lower Contribution Levels
Permanent Plan DesignNot Good With Many Employees
High Administrative FeesMinimal Plan Costs

SEP IRAs are simple to set up and administer and offer flexibility regarding how much and when contributions are made. However, they may not be the best option for all employers, as they do not provide the same flexibility and customization as other retirement plans, such as 401(k) plans.

Advantages of a SEP IRA

Here are five advantages of a SEP IRA:

  1. Easy to set up: SEP IRAs are relatively easy to establish and maintain, with minimal paperwork and no annual IRS reporting requirements.
  2. Contribution limits: Employers may contribute up to 25% of each employee’s compensation or a maximum of $61,000 per employee (whichever is less) for the 2021 tax year. This can provide a significant amount of retirement savings for both the employer and employees.
  3. Tax-deductible contributions: Employer contributions to a SEP IRA are tax-deductible, which can help reduce the company’s taxable income.
  4. Tax-deferred growth: SEP IRA contributions grow tax-deferred, which means investment earnings are not taxed until the funds are withdrawn in retirement.
  5. Easy to administer: SEP IRAs are relatively easy to administer, with no annual IRS reporting requirements or discrimination testing. This can save time and money compared to other retirement plans, such as 401(k)s.

Benefits of a cash balance plan

  1. Predictable retirement benefits: Cash balance plans provide a predictable retirement benefit, as the benefit is based on a stated account balance rather than on years of service or final average pay.
  2. Employer contributions: Employers make contributions to the plan on behalf of their employees, which can help employees save for retirement without having to contribute their funds.
  3. Portability: Cash balance plans offer portability, as employees can take their accrued benefits with them if they leave the employer before retirement. You can find this on the TPA illustration.
  4. Insured by the PBGC: Cash balance plans are insured by the Pension Benefit Guaranty Corporation (PBGC), which provides some level of protection if the employer cannot meet its obligations under the plan.
  5. Tax advantages: Contributions to cash balance plans are tax-deductible for the employer, and investment earnings grow tax-deferred until withdrawals are made in retirement. This can provide tax advantages for both the employer and employees.

Cash Balance Plan vs SEP IRA

So there you go. This post looked at the cash balance plan vs. a SEP.

A SEP is best if you want small contributions from $15,000-$40,000 instead. It also is simple to establish with minimal administration.

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But if you are looking to get $75,000+ into a plan, then a SEP won’t get it done. You will have to move up to another plan design. The good news is that cash balance can often accommodate contributions over $350,000.

How does a cash balance plan work?

A cash balance plan is a hybrid retirement structure that is technically a defined benefit plan. It requires actuary certification on schedule. SB.

It is called a hybrid plan because the contributions and benefits are calculated using actuarial assumptions. However, the plan presents itself more like a 401(k) plan because there are individual participant statements. These plans work great for small businesses where the owner has substantial taxable income.

What is a SEP IRA?

A SEP is technically a defined contribution plan. It acts similar to a profit-sharing plan. The company can make annual contributions to eligible employees up to 25% of their compensation.

The plans are simple to set up and have virtually no annual compliance requirements. For this reason, they are great starter plans for small businesses. But as owners generate higher income and want to make more significant contributions, they will typically graduate to a cash balance plan.

The cash balance plan is certainly the more complex structure. They can be expensive to set up, and you must hire an administrator (TPA) to manage the plan.

But you can’t go wrong with a cash balance plan if you want significant contributions. It might be the retirement home run you’ve been looking for.

Paul Sundin

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