Cash Balance Retirement Plan: Our Favorite Structure [+ IRS Hazards]


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Even though recent tax reform has lowered tax rates, chances are you still are looking for a few tax breaks. Have you ever considered a cash balance retirement plan?

No one really likes to pay taxes and most of us will try to find a way to legally avoid taxes the best we can. Fortunately for you, I am here to tell you about a little-known strategy to massively reduce your annual taxes.

The cash balance plan is your safest bet to create a retirement pension plan for yourself in the most tax-efficient manner possible.

Cash balance plans are certainly more complex compared to basic 401k plans. But don’t be intimidated. Once you know the basics, you might find that they will work great in your situation.

What is a cash balance retirement plan?

A cash balance plan is a fresh twist on a traditional defined benefit/pension plan.

Like in a traditional DB plan, the participant in the cash balance plan is also told that he or she will receive a certain guaranteed amount on retirement. The participant can choose to take out the amount in lump sum or commit to an annuity that pays a portion of the guaranteed amount in regular checks, upon retirement. The contributions made to the plan are completely tax-deductible, which means that every dollar saved is a dollar not taxed.

However, the feature that differentiates it from a traditional pension plan is that it also works like a 401k plan (defined contribution fund), where each participant has his/her own individual account, in which the employers make monthly contributions.

Financial planning puzzle piece

The participants are sent an individual statement which shows the hypothetical account balance or the benefits that the participant has earned over time. Due to the cash balance plan sharing common features of both defined benefit funds and defined contribution funds, they are sometimes referred to as “hybrid plans”.

How does it work?

For each year, the employee works for his company, the benefits into his cash balance plan will accrue using the following formula:

Annual benefit = (Wage x salary credit rate) + (account balance x interest credit rate)

Let me explain this formula with the help of an example. John earns $100,000 in salary annually. The ongoing salary credit rate in the company he works for is 5%, which represents the percentage of the employee’s wage that the employer must contribute annually in the plan. This means that the employer must contribute $5,000 as “compensation credit” to John’s plans each year. This is the first component of the annual benefit to be accrued to John.

The second component is the amount the employer must contribute for the “interest credit” or growth of the cash balance plan, which can be found out by multiplying the year beginning account balance with the interest credit/growth rate.  The interest rate could be fixed or variable as it is tied to an instrument, like the interest on a 30-year Treasury bond.

If the account has an opening balance of $400,000 and the interest credit rate is 6%, this will mean that the employer must contribute another $24,000 for John’s plan. The total annual benefit will amount to $29,000 as given by the calculations below:

Annual benefit = (Wage x salary credit rate) + (account balance x interest credit rate)

Annual benefit = ($100,000 x 5%) + ($400,000 x 6%)

Annual benefit = ($5,000) + ($24,000)

Annual benefit = $29,000

Benefit to Small Business Owners

If you are a small business owner, the cash balance plan will give you the option of contributing more to your retirement plan than the traditional 401k or Roth IRA account, as shown in the table below.

Many people also use the cash balance plan in conjunction with their 401k plans to maximize their annual contribution limits and hence their tax savings. Usually, successful business owners are in their early 40s and are making a consistent income of $200,000 or more, annually.

They have only recently started making this amount of money and now they want to save it up. Till this point in their lives, they haven’t been able to save much due to heavy capital investments in their businesses and other expenses due to which their retirement funds are almost non-existent.

The cash balance plan is an ideal solution for them to turbocharge their retirement savings plan. As you can see from the table above, cash balance plans are age-dependent and older participants can contribute more annually to this tax haven and boost up their retirement plans significantly.

With a cash balance retirement plan, each owner will have an individual account. This makes it easier to allocate a different amount to each owner since they might have different retirement ages. The owner can also make his spouse as a partner in the business which could potentially double the amount of contributions that can be made in the plan.

Cash Balance Retirement Plan Rules

The hypothetical cash balance pension accounts are a bookkeeping device to keep track of participants’ accrued benefits and are not directly related to assets in the plan. A cash balance plan is considered a specific type of defined benefit plan because accrued benefits are not determined solely by the value of investments.

Because it is a defined benefit plan, employer contributions are calculated using actuarial assumptions and funding methods. The trust asset value will usually differ from the sum of the participants’ accounts.

Spouse consent is also necessary for any non-joint and survivor form of benefit. Joint and survivor percentages must be 50% larger. Pension payment cannot be split between spouses, except when a court orders so due separation or divorce.

Contributions are formula-driven. The formula is spelled out in the plan document. It is usually a percentage of compensation or a flat dollar amount. In practice, the amounts below will vary depending on the annual salary.

How to structure a plan

As a qualified pension plan, employers offer a cash balance plan to eligible company employees as a retirement structure. The employer must contribute a percentage of employee compensation and an interest credit.

Suppose an existing defined benefit plan amendment converts a cash balance defined benefit plan. In that case, the participant’s account balance is the sum of the former accrued benefit plus any benefit earned from post-conversion service under the cash balance formula. Conversions must preserve the accrued benefit with all future services creating cash balance account additions.

Are employee contributions to a cash balance retirement plan allowed? No, they do not. Cash balance plans do not allow employee deferrals. The company solely makes contributions. The company must ensure adequate funds to contribute to all qualifying employees. If employees are looking for an additional way to contribute, they will need to do an employee deferral on a 401k plan.

Final Thoughts

Due to the flexibility of cash balance plans and the fact that they are one of the best tax havens out there, they have increased tremendously in popularity in recent times.

Paul Sundin

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