Cash balance plans have complicated rules and can be difficult to understand. Many people ask: is a cash balance plan the same as a pension?
Many of us use the words pension and retirement plan interchangeably. A retirement plan is just an overall tax-deferred structure whereby investments will grow and are not subject to tax until they are withdrawn upon retirement.
But a pension is technically defined a little differently. A pension will provide a guaranteed amount at retirement or an actual guaranteed annual contribution amount. So actual retirement plans that qualify as a pension would be a traditional defined benefit plan, cash, balance plan, or even a money purchase plan.
Is a cash balance plan the same as a pension?
Yes. But it is a certain type of pension that presents itself more like a 401(k) plan. A cash balance plan is a unique type of defined benefit pension plan, which means that it provides a specific benefit to employees at retirement.
Like other defined benefit pension plans, a cash balance plan is funded by contributions made by the employer and/or the employee, and the benefits are typically paid out in the form of a lump sum or an annuity upon retirement.
However, there are some key differences between a cash balance plan and a traditional pension plan. In a traditional pension plan, benefits are typically based on an employee’s years of service and salary history, whereas in a cash balance plan, benefits are based on the individual account balance that is credited to each participant.
Additionally, cash balance plans are portable, meaning that employees can take their account balance with them if they leave the company, whereas traditional pension benefits may be lost if an employee leaves the company before they are eligible to retire.
Overall, while cash balance plans are similar to traditional pension plans in some ways, they have some important differences that make them a distinct type of retirement plan.
What is a pension plan?
A pension plan is a retirement plan that provides a specific benefit to employees upon retirement. There are several different types of pension plans, including defined benefit pension plans and defined contribution pension plans.
In a defined benefit pension plan, the benefit that an employee will receive at retirement is predetermined based on factors such as the employee’s salary and years of service. The employer is responsible for making the necessary contributions to fund the pension benefits. Defined benefit pension plans are often referred to as “traditional” pension plans.
In a defined contribution pension plan, the employee and/or the employer make contributions to an individual account that is used to save for retirement. The benefits that an employee will receive at retirement depend on the amount of money that has been contributed to the account and the investment returns earned on those contributions. Examples of defined contribution pension plans include 401(k) plans and individual retirement accounts (IRAs).
Overall, a pension plan is a type of retirement plan that provides financial security to employees during their retirement years. It is important for employees to understand the terms and conditions of their pension plan, as well as the potential risks and benefits of participating in the plan.
Cash balance plan basics
In a cash balance plan, each participant has an individual account balance that is credited with a fixed percentage of their pay each year, as well as additional credits based on the investment returns on the plan’s assets. The employer may also make contributions to the plan on behalf of the employee.
When an employee retires or leaves the company, they can typically choose to receive their benefits in the form of a lump sum payment or an annuity. An annuity is a payment that is made to the employee on a regular basis, typically monthly, for a specified period of time or for the remainder of the employee’s life.
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The benefits that are paid out from a cash balance plan are typically based on the employee’s account balance at the time they retire or leave the company. This balance is calculated by adding up all the contributions that have been made to the account, as well as any investment returns earned on those contributions.
It is important to note that the terms and conditions of a cash balance plan can vary, and it is important for employees to understand the specific details of their plan. Employees should also be aware that cash balance plans are subject to certain legal requirements, including minimum funding requirements and vesting schedules.
In reality, the word pension is used to describe many different types of retirement structures. But it is a technical definition of a cash balance plan.
But I would not get too concerned about formal definitions. A cash balance plan will allow for a specified amount at retirement, and it is an excellent tax deferral strategy.
If you’re a business owner or a self-employed professional, consider a plan an important part of your retirement toolbox.