If you are considering to start a retirement plan and setting aside some money, a cash balance pension plan may be for you. In this post, we will examine how to set up a cash balance plan in 5 simple steps.
Cash balance plans have been gaining momentum in the recent years as employers try to lure key talent to their companies. With proper management, a cash balance plan is a great way for small-scale businesses and companies to substantially boost their retirement savings, to lower their tax payable and offer employees better retirement funds.
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Why a Cash Balance Plan?
A cash balance plan is a defined benefit plan but highly resembles a defined contribution plan, gaining the name “hybrid” plan. It was considered extinct some years back until the Pension Protection Act of 2006 was enacted, shading light to what cash balance plan needed to get IRS approval.
Cash balance plan rules allows for high contribution to your retirement, well over $100,000, way higher than roughly $50,000 for 401(k) plans. This is possible for key employees nearing their retirement age, 50 years and above, with cash balance plan, 20-year savings could be done with less than 10 years.
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Another reason to go for the cash balance plan is for the tax deduction. Contributions towards a cash balance plan are deductible for the employers, which could range from $50,000 to $250,000 per year depending on age and income levels of plan participants.
How a Cash Balance Plan Works
An employee’s account earns a pay credit, normally 5% of their salary each year, plus an interest credit, at a fixed rate or variable rate on your account balance. As pointed out, increases or decreases in a portfolio’s value does not affect the contributions, and the employer is the one bearing this risk.
A participant under a cash balance plan receives benefits defined in terms of their account balance. Assuming an employee has $100,000 by the age of 65 and decides to retire, they will be entitled to an annuity based on this balance, which is about $8,500 annually for life. The company will be able to manage the plan assets.
How to Set Up a Cash Balance Plan
Starting a cash balance plan may be easier than you thought. We will break out below the 5 steps that are involved in plan set up. The key is to make sure that you have a quality third-party administrator that can help you set the plan up and work with you on plan design.
- Get a financial advisor and/or a CPA. First, get a financial or tax adviser as they can help you navigate the process. The adviser will collect relevant employee information such as ages and their salaries. This information is used to calculate the amount to be contributed to the plan for business owners and executives, and how much to contribute to the employees. IRS requires that a plan passes non-discriminatory testing in terms of favoring owners and key employees.
- Draft the plan document. Put together a legal document outlining all the plan details, the contributions to be made and the interest rates. The document is to be signed by the end of a tax year that the company wants to take the deduction.
- Make required contributions. Make contributions by the due date of your tax returns. If an extension is obtained, contributions should be made not later than eight and a half months after the year ends.
- Establish a monitoring process. You should have standards to ensure that your business will be able to meet the yearly contributions. Continuous reviews should be done on the returns made by plan assets and make a decision to change the interest rate, to amend or freeze the plan before the plan becomes a liability to the employer. The plan can be terminated in certain situations and the plan assets distributed.
- Find a quality third-party administrator. Look for a third-party administrator (TPA) to help manage the plan. This is an organization specialized in offering services to other companies on pension plans. Managing all plan activities may be a hard task for you and you must have an actuary involved. Therefore, contract a third-party administrator to handle much of the hefty administrative work so you can concentrate on the remaining investment work.
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Set up for 2021 or 2022
|Tax deductible funding||Permanent plan structure|
|Flexible min/max/target contribution levels||Mandatory annual funding|
|Large (sizable) annual contributions||Higher plan fees|
Who can set up and manage a cash balance plan
The cash balance plan is funded by the employer. Depending on your age and business income, a cash balance plan can have contribution levels in 2021 as high as $3 million.
A cash balance plan is a great pension option for your company. It offers accelerated retirement savings and increased tax deductions. But it might not be the best option unless you make a constant cash flow or profit margins annually.
While changes are allowable along the way, frequent changes may prompt IRS to consider your plan a cash-deferred arrangement rather than a pension plan. A good plan is the one that combines a 401(k) alongside a cash balance plan.