Cash Balance Pension Plans Explained: Rules + Formula Example [Video]

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You have probably heard of all the benefits of a cash balance pension plan. But how much do you know about the rules or how the formula works?

It is often referred to as the #1 retirement strategy for business owners. But before you set up a plan, you should carefully examine the benefits and pitfalls.

In this post, we will show you how these plans work. We will also answer the following questions:

What is a cash balance plan?
Cash balance plan rules and requirements
How to structure a plan for your business
Cash balance retirement plan strategies

We also have some videos and an example that will explain some of the important rules and requirements. Let’s jump in!

What is a cash balance plan?

What is a cash balance plan?

A cash balance retirement plan is special type of retirement structure that allows business owners to make large tax-deductible contributions. You can think of it as a 401(k) plan on steroids. In fact, annual contributions can be as high as $300,000 or more.

In the right situation, they can be a home run. There just are not that many structures that you can contribute 6 figures and get a full tax deduction.

Many business owners are searching for tax deferral strategies and a way to accelerate their retirement savings. These plans address these two issues.

How does it work and what are the rules?

So let’s start with understanding some retirement basics. Retirement plans are classified into two main categories: defined benefit plans and defined contribution plans.

Defined benefit plans look to generate a specific benefit at retirement. However, defined contribution plans work a little differently. They specify a maximum contribution limit upfront.

The 401(k)

You know how a 401(k) establishes maximum annual contributions? That’s because it falls under the defined contribution category. In contrast, a cash balance plan falls under the define benefit plan category.

A 401(k) has an annual employee maximum contributions. Once you contribute, the account can grow to $1 million or it could go to zero. For plan purposes, it doesn’t matter.

The defined benefit plan

Before you ask what is a cash balance plan, you need to understand how a defined benefit plan works. But a cash balance retirement plan doesn’t have that same annual limit rules like the 401(k) plan does. It is actually trying to contribute enough money so that you have a specific account balance when you retire (typically at age 62).

How much money you have when you retire is dependent on a few things. But most importantly, it is how much compensation you were paid over the years.

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Assuming you meet the criteria, you can have approximately $3 million when you retire. You get the point. It’s a nice nest egg.

How do the contributions work?

So here is what’s special about these plans. All things being equal, the older you get the more you can contribute and the larger the tax deductions. As a result, allowable contributions will increase with age.

Here’s how it works. Let’s assume there are two employees who both make $50,000 a year. One employee is 35 years old and the other is 55 years old. In theory, they both should have the same retirement benefit at age 62.

Only a small contribution is required because the 35 year old has many years until retirement. But the 55 year old just has 7 years to hit the plan retirement age. As such, you can make a much larger contribution.

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Set up for 2022 or 2023

So therein lies the beauty of the plan. Most high income self-employed people tend to get more serious about retirement (and have more money) when they are in their mid-forties and fifties. Annual contributions in the age range can often exceed $100,000 annually.

How much can I contribute to a cash balance pension plan?

Basically all retirement vehicles have some form of contribution limit. Cash balance plans are really no different.

As stated previously, contribution limits are highly dependent upon employee age. The table below is meant to give you a general idea of contribution limit based on age.

But please realize that these are estimated amounts and final numbers are determined by an actuary. So use these as a guideline and not as a rule:

AgeMax Annual Contribution

Here’s a tip to get a bit more into a plan. A new plan (one that is not a conversion of an existing defined benefit plan) can grant “past” or “prior” service in the form of an opening cash balance credit. These rules allow for a larger plan contribution in year one.

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Business owners do enjoy some flexibility under a cash balance pension plan. The owner has some control over which employees they can contribute for and how much (subject to IRS non-discrimination rules).

What companies are best suited?

Now that you understand the basics, let’s look closely at the companies that are great candidates for these plans. As a general rule, a company should have the following qualities:

  1. Consistent cash flows and high profits.
  2. High marginal federal and state tax rates.
  3. The goal of aggressively accumulating retirement savings.
  4. The desire to get large tax deductions.
  5. The motivation to “catch-up” on retirement planning.

The ability to contribute a larger amount per year based on each individual’s age, make a cash balance defined benefit plan very attractive for any small business owner.

But be careful. Many small business owners want to re-invest as much of the business profit back into the company. 

Who else could benefit from a cash balance retirement plan?

Others who may benefit from plans are (for example):

  • Companies with large income streams and the ability to contribute the minimums to a cash balance plan.
  • Companies who want to combine retirement structures and seek bankruptcy and creditor protection.
  • Companies wanting to provide an attractive employee benefit to motivate staff who play a key role in the company.

Tell me about my investment options?

Many people think that the third-party administrator who sets up the plan will also manage the plan assets. Alternatively, they often believe that they must contribute their funds into a specific investment vehicle. This is far from the truth.

Most companies will open up an account with their financial advisor or a traditional discount broker like Charles Schwab, Fidelity, Etrade or Vanguard. We have relationships with all the large custodians to help expedite the plan set-up process.

These plans do not have to have a “special” account. The reality is that the plan establishes a trust. This example trust is similar to what you would have with a 401(k) plan.

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Plans can invest in stocks, bonds and mutual funds. This is similar to a 401(k) plan. Employees cannot chose individual assets as all funds are in a pooled account.

Take a look at the video below to understand your investment options:

what is a cash balance plan and what are the rules

How can I customize a cash balance pension plan?

The good news is that there is some flexibility in plan design rules. These plans can be customized to slant in favor of the business owner.

The plan administrator (or TPA) can run multiple illustrations to compare different plan options. For example, the company can contribute different amounts for different participants.

Cash Balance Pension Plan

Funding reductions are not allowed when employees reach 1,000 service hours. Plans can be terminated or frozen. But only before employees reach 1,000 hours. This is the case only if the company does not want to make a contribution for the current year.

Can plans be combined with other retirement structures?

As an employer, you have the option to combine a 401(k) profit-sharing plan with the cash balance plan. As an owner, you can decide how much you want to contribute based on your company’s profits at year-end.

What is a cash balance pension plan, rules, cash balance retirement plan

If you set up your account as a safe harbor plan, you’ll need to make a contribution each year. It doesn’t matter what your profits are – you must contribute the amount stated, typically around 4%.

Fortunately, you can deduct the safe harbor amount from the profit-sharing amount, reducing the amount you must contribute.

What are the risks I should consider?

The company should always discuss the pros and cons of any new retirement plan up front. Since each plan type has different features, it is helpful for the advisor or benefit consultant to compare and contrast the most important features between plans.

Financial and legal risks are a prime consideration, and these can be managed by ensuring compliance tests and government filings are completed accurately and timely.

If assets return more than expected, the employer contribution will decrease (all other assumptions being satisfied). On the other hand, poor returns require increasing employer contributions.

What are the cash balance pension plan rules?

Now that you understand the basics, let’s take a look at a real life example. This plan is rather straightforward. It is for a small law firm.

Small companies who operate as sole proprietorships (and have no employees) are certainly able to set up cash balance plans. We typically refer to these plans as solo or one person plans.

The business owner can establish a plan and provide funding for just himself or herself and may also be able to contribute for a spouse that works at the company.

In this example, the husband is the attorney and the wife performs administrative services. The plan was structured as follows:

defined benefit plan rules for law firm

The above example plan suits him and his wife just fine. They are able to get $240,500 into the combined 401(k) profit sharing plan and the cash balance plan.

Please note that the basic 401(k) plan (with profit sharing) allows a profit sharing maximum contribution of 25%. But when the plan is combined with a cash balance plan it is limited to only 6% (subject to other rules).

What if I want to terminate the plan?

A cash balance pension plan meets the definition of a defined benefit plan. The employer bears the cost of contributing to the pension.

At retirement, the employee may choose to accept the vested benefit as a lump sum distribution. The employee may also roll the plan into an IRA to allow the monies to continue to accrue interest.

Get Started for $990

Set up for 2022 or 2023

Should an employee leave the company before retiring, he or she may request a distribution of the vested account balance. Alternatively, they may roll the entire fund into an IRA.

Under a traditional pension plan, employees do not have the option to roll funds over. Instead, they will receive a reduced annuity or a lump sum when they finally retire.

There are many steps in the termination process. Take a look at the video below for an example:

cash balance retirement plan
Design FeaturesPlan Restrictions
Large Owner AllocationsPermanent Plan Design
Tax-Deferred Investment GrowthHigh TPA Fees
Owner-Only OptionCombo Plan Rules

Cash balance pension plan FAQ and example

What are the benefits of a cash balance pension plan?

These plans have a lot of benefits. So let’s take a look:

* They are “qualified” plans, which means that they qualify for tax deferral status.
* They are not subject to the traditional contribution limits and rules associated with 401(k) plans.
* Qualified plans offer creditor protection. This protection comes under ERISA.
* They are generally protected from bankruptcy and lawsuits.
* They work great for sole proprietors, S-corps and C-corps and other structures.
* They can be combined with other retirement structures, such as a 401(k).
* A solo plan or one person plan can use the Mega Backdoor Roth.
* They allow for portability. The employee can roll the funds into an IRA.
* Did I mention that contributions are tax deductible?

What are the pitfalls associated with cash balance pension plans?

But those large contributions come with a price. These plans are more complex and more expensive to administer. Ensure that your financial planner and CPA are on board. Most don’t understand how they work.

Like any plan, there are some disadvantages. Let go through them:

* Cash balance retirement plans are permanent and contributions are not elective.
* You should keep them open for at least 3 years. You can terminate for good cause.
* An actuary must review and certify plans each year.
* They are expensive to administer. Most plans will run $2,000 or more annually.
* The plans often have rules and restrictions on the lump sum payment options.

How does the formula work?

Let’s look at an example of how the pay credit formula works. You don’t have to be a CPA to understand how it works (but it might help). Here is the easy five-step process:

* Beginning of the year balance is $10,000
* Interest crediting rate is 4%
* W2 compensation of $100,000
* Pay credit is based on 5% of pay
* End of year balance is ($10,000 × 1.04) + ($100,000 × 5%) = $15,400

Remember that the hypothetical account balance is simply a bookkeeping example utilized to track each participant’s account balance. It does not tie directly to the plan’s asset balance.

Beginning of the year balance$20,000
Interest crediting rate5%
W2 compensation$200,000
Pay credit5% of pay
End of year balance$31,000

Bottom line

Cash balance plans are becoming increasingly popular, and they are great plans for the self-employed. With many business owners looking for significant tax deductions, asset protection, and the ability to make sizable retirement contributions, cash balance plans make great options.

Through pension reforms over the years, the plans have become more flexible and offer streamlined administration. Make sure you consider them in your retirement arsenal. Hopefully, this cash balance plan guide and example has helped you understand the basics.

Paul Sundin

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6 thoughts on “Cash Balance Pension Plans Explained: Rules + Formula Example [Video]”

    • Hi Tricia – the issue usually comes down to how much you want to get into the plan. Of course it depends on age and income. But if you want to get $50k or so into a plan then usually the 401k will make most sense. But if you are looking to get more then that you would want to consider a cash balance plan. So it really comes down to your desired contribution and if you think you will have consistent income for at least the next several years.

    • Robert – we currently set up a cash balance plan for $990. Annual administration will run you $1,950. Let us know if we can help.

  1. I’m self employed with solo 401k. My spouse has 403b and 457 plan with her job. Could she still participate in cash balance plan as shown in your article.

    • Hi Luke – You can of course have a cash balance plan. She can contribute to the same plan as you only if she works for you. I am not sure if she does provides any services for your business or not. But if she is on your payroll and meets all the eligibility requirements, then the company can contribute for her.


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