How Does a Cash Balance Plan Work With Employees?

So, you set up a solo cash balance plan where you were the only employee. Maybe you’ve included your spouse in the plan.

Either way, your plan qualified as a solo plan and had limited testing procedures. Plus, the plan was easy to administer because you had more control over your compensation and funding levels.

Now you’re considering adding an employee or two. But before you hire any employees, you’re trying to determine how much this will impact your cash balance plan funding.

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In addition, you wonder how much you will have to contribute for this employee? You’re willing to give them some amount. But you want to keep the allocation minimal.

This post explains everything you should consider when hiring employees. This includes estimated contributions and how the employees will impact your plan. Let’s jump in!

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Employee eligibility restrictions

If you have a plan set up through Emparion, we will generally include some basic eligibility restrictions. We will typically include the maximum restrictions that the IRS allows.

The goal is to limit employees upfront from being plan participants. We will also separate the employees into a different “group” that gives the employees a much lower contribution compared to the owner.

The owner can still get a large contribution. But the eligible employees will have to get a small amount in order to pass IRS testing.

Here are the eligibility restrictions your cash balance plan most likely has. It will restrict the following employees:

  • Those under the age of 21;
  • Those who work less than 1,000 hours; and
  • Most importantly, employees who were hired during a given year.

If you plan to hire a new employee today, we have some good news for you. That employee will be excluded from eligibility in the year they are hired, and you will not have to contribute for them. As such, the plan is still considered a solo plan.

But assuming they’re a full-time employee, they will participate the following year, and you’ll have to contribute for them.

Two questions to answer when you have employees

The owner had a lot of control over the plan funding when they had no employees. But when you add employees, you must ask yourself the following questions:

  1. What is the desired total retirement contribution I would like to make going forward?
  2. What is the largest amount of the desired contribution I would be willing to give to my employees?

Remember that the owner gets a tax deduction for the entire contribution amount. If they are in the 40% tax bracket, every dollar allocated to employees will only cost the employer 60 cents.

How much of a contribution do you have to make for your employees?

If you have been making $100k plus contributions for yourself in the past, you will be happy to hear that your employee contributions do not have to be that large. But you should plan on contributing 10% of their W2. We’ll discuss why.

The first thing you need to understand with any defined benefit plan structure is that contributions are driven largely by age, W-2 compensation, and investment returns. Age and compensation are the most important variables.

Regarding group plans, the plans really like disparity between age and compensation. We want older and higher-paid owners, along with younger and lower-paid employees.

Let’s assume that you hired a 35-year-old full time employee. They were excluded in year one, but they were still employed by you through year two.

So, if the new employee was age 35 and was paid $35,000 a year, that would tend to work well for a 50-year-old owner with a W2 of $150,000. But if the owner was age 32 and has a W2 of $50,000, that might not work out great.

How much age and income disparity do you want? The larger the age and compensation disparity, the better the allocation to the owner.

What is considered a good allocation?

Generally, a plan that allocates a minimum of 85% to the owner is reasonable. The goal is usually 85% to 90%.

But what if an employer hires 5-10 employees and can only get 60% allocated to them? Is this a bad plan?

Not necessarily. It depends on the owner’s goals and tax bracket. It may not make sense if the owner was in a low tax bracket and had no state income tax. However, if the owner makes $1 million annually and lives in California, they would have a tax bracket of around 50%. The plan economics makes much more sense.

Also, many owners with employees use the plan as an employee fringe benefit. They could fund the plan instead of giving out bonuses or to improve retention. This can make a lot of sense, especially for older owners close to retirement.

How does vesting work?

We have already established that employers should estimate 10% of employee contributions and that a good plan design will usually allocate at least 85% to the owner. But we’ll show you how to improve these numbers.

First, the IRS allows you to make defined benefit plans subject to vesting. This means that even though you may have to contribute for an employee, they don’t have the right to that contribution until it is “vested.” Vesting essentially means ownership.

While you can have immediate vesting, most defined benefit plans will have 3-year cliff vesting. This means an employee must work for you for three years to become vested in the contribution. So, if they leave the company or are terminated before three years, all the contributions get forfeited and are reallocated to all employees. Assuming you receive 90% of the total allocation, 90% of this forfeiture will be reallocated to the owner.

As a general rule, your average employee retention is around three years. As a result, half of your employees will become vested, and half will terminate before three years and will forfeit their contributions.

Of course, retention rates will vary across industries and pay scales. But this is a reasonable assumption. The result is that half of your employee contributions will be forfeited. This will increase your effective allocation from 90% to around 95%. The overall allocation and plan economics has risen drastically.

Employee example

Let’s look at an example. Assume we have an owner and two employees. All are eligible participants. Here are the details:

AgeCompensation
Owner55$200,000
Employee #140$50,000
Employee #230$30,000

Here are how the numbers look assuming a combo plan with a 401k:

As you can see, the owner is allocated 95% of the total retirement contribution in this illustration. Assuming that half of your employees will not vest, this economic value increases to 97.4%.

Remember the disparity issues we discussed above. Of course, you cannot change your age, but the owner could increase their W2 to $330,000 (the most allowed for plan purposes). This can enable a larger contribution to the owner and, of course, an improved allocation.

With this plan design, the owner gets an immediate tax deduction for the total contribution of $172,290. Assuming a 40% tax bracket, this results in an immediate tax savings of $68,916.

Plus, to make things better, of the total non-owner employee contribution of $8,810, upwards of half of this will most likely be forfeited and come back to the owner. Not such a bad deal.

Final thoughts

Adding employees to a cash balance plan or defined benefit structure often leads to questions. Most owners are willing to give some contribution amount to their employees. They just don’t want to give them “too” much.

The owner should also assume they must contribute 10% of pay to each employee. Of course, this estimate will give owners a rough idea of whether it makes sense. But you can have your administrator run an illustration to give you a better idea.

Once you look at the numbers, you might find that the economics are not that bad. However, if an employer plans to hire 10+ employees, the plan usually will make little sense.

Make sure you lean on your plan administrator to look at your employee mix and give you estimated amounts. They can run a couple of illustrations so you can get an idea of the contribution amounts.

Paul Sundin

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