Cash balance plans come with a complex set of rules. Often, clients ask: If I have employees, why don’t I just have a standalone cash balance plan? Is there a reason I must also have a 401(k) profit-sharing plan?
It’s important to note that the IRS requires “cross-testing” between these two different retirement plans. This means that even though each plan has its own set of rules, when they are both being funded there are additional rules that must be met for the plans to be compliant.
As a result of these testing rules, you will find that the vast majority of employers MUST have a 401(k) profit-sharing plan when they have a cash balance plan. We’ll discuss the specific cross-testing rules in this post!
Some background
Cash balance plans and 401(k) plans work closely together. Even though they’re different types of plans, actuaries will use IRS rules to ensure the plans pass testing.
Why must these plans be tested together? The IRS has non-discrimination rules to ensure the plan benefits are not only going to the owner. Said differently, if the owner gets a specified contribution, the employees must get a large enough contribution to satisfy the rules. Of course, most of the contribution can go to the owner. But employees must receive something.
This discussion is irrelevant if the owner is the only employee. While there are still compliance rules, you can easily have a standalone cash balance plan.
But most clients are searching for substantial contributions, so it is simple to also fund a 401(k) plan with a profit-sharing contribution. However, the cross-testing rules come into play when you have a group plan with non-owner employees.
You will find out shortly that the most economical solution requires you to have a 401(k) profit-sharing plan when you also have a cash balance plan.
Cash balance plan illustration
Business owners are usually presented an illustration that will breakout the contributions between the cash balance plan and the 401(k) plan. This illustration will further detail the contributions allocated between the owner and employees.
When this is presented to the owner, they often question the contributions and the amounts allocated to the employees. Their first question is why they just can’t have a cash balance plan and skip the 401(k) contribution. The assumption is that the profit-sharing 401(k) is costing them money.
Complicating this issue is the fact that most cash balance plans only require a 2 to 3% of compensation contribution for the employees. But in many situations owners can get 100% of compensation or greater into the plan.
So, if you look at an illustration standalone and you take the profit-sharing contributions out, it appears like you would have a larger allocation to the owner. But that is actually incorrect.
But the reality is, the 401(k) profit-sharing is surprisingly saving them money. For the cash balance plan to make economic sense, it must have the 401(k) as an offset to pass the testing rules.
Why must a group plan have both plans?
The reason a group plan must have both plans is for testing purposes. I will give you the technical reason below, and then I will provide you with a plain english answer afterward.
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Technical answer
When you test the benefits provided under the two plans, the defined benefit amount will be projected to normal retirement age (NRA) using the interest crediting rate (normally 4% or 5%). This amount is then converted to an annuity using required plan assumptions and mortality table.
The Safe Harbor Non-Elective Contributions (SHNE) plus profit-sharing contributions get projected to normal retirement age at an 8.5% rate. It is then converted to annuity using 1971 Male mortality table.
Using the different interest rates and mortality tables results in a benefit calculation that provides most of the owner benefit in the defined benefit plan and most of the staff benefit in the 401(k) profit-sharing plan.
Plain English answer
To break the above down in plain English, here is the answer:
The actuary will cross-test the plan. The IRS requires the actuary to use different interest rates and mortality tables for each plan. Because of these calculation differences, profit-sharing contributions receive a much great weighting compared to cash balance plan contributions.
Is a Cash Balance or Defined Benefit Plan Right For You?
The end result is that approximately four dollars in cash balance plan contribution equals one dollar in profit-sharing contribution. That’s why companies truly need the employee profit-sharing contributions to limit the overall employee contribution. If there was no profit-sharing plan in place, the overall employee contribution would be substantially higher.
Example
Let’s look at an example. Let’s assume you are a dentist and you have five employees. Your contribution to a defined benefit plan and 401(k) profit-sharing might look like the following:
| Cash Balance Plan | 401(K) PS | Total | Percentage | |
|---|---|---|---|---|
| Owner | $300,000 | $1,000 | $301,000 | 91% |
| Employees | $10,000 | $20,000 | $30,000 | 9% |
| Total | $310,000 | $21,000 | $331,000 | 100% |
I would consider the overall contribution in the above table to be a favorable plan design. Of the total contribution, 91% is going to the dentist/owner.
But the owner might say: let’s just eliminate the profit-sharing plan, and that way I can keep my overall employee contribution lower. But if you did that, your numbers might look like the following:
| Cash Balance Only | Percentage | |
|---|---|---|
| Owner | $300,000 | 81% |
| Employees | $70,000 | 19% |
| Total | $370,000 | 100% |
As you can see, when you take out the profit-sharing component, the employee contribution to the cash balance plan substantially increases. The dentist is now receiving only 81% of the total contribution. The overall economics got substantially reduced.
Final thoughts
It is common for business owners to assume they can simply eliminate their profit-sharing plan and reduce the employee contribution. But you can see that this is simply not the case.
Discussing these issues with your plan administrator is paramount. It will allow you to plan more efficiently and provide the best overall plan allocation to the owner.
