Cash balance plans are complex. Understanding the pros and cons is not easy. Most business owners have heard about the advantages of these plans. However, how many business owners understand the disadvantages?
These plans should be carefully analyzed based on your business situation in order to determine if they are a good fit. When we discuss the plans with clients we always make it clear what the downsides are. If you can live with the disadvantages, the upside will take care of itself.
In this article, we provide an overview of the advantages and disadvantages. We provide a couple videos and some tables to make sure to illustrate the issues.
Table of contents
Plan Pros or Advantages
Many folks see the advantages of cash balance plans and jump right in. But don’t jump in too fast. You must carefully review the pros & cons and do you due diligence. Let’s examine the pros and break them down for you.
Substantial Contributions
This advantage is the #1 reason why people set up plans (aside from the tax deductions). A cash balance plan allows the largest contributions compared to any other retirement structure.
The plans don’t technically establish annual contribution limits much like a 401(k) plan. Because they are a type of defined benefit plan, the goal is generally to have a substantial and identified amount at retirement. As a result, annual contributions are often as high as $300,000, subject to income, compensation and age.
Here’s the bottom line – if you are looking to get $100,000+ annually into a plan then this is typically the #1 option. A 401(k) does not come close in this situation.
Funding Range & Flexibility
Many people think that plan contribution are fixed. While these plans can be structured as fixed or selected contributions, most plan structures will allow a flexible funding range.
In the vast majority of plan designs, you are given a contribution range. The range will identify a minimum, target, and maximum funding level. Normally, the target amount is somewhere in the middle but closer to the minimum.
This funding range allows you to make more significant plan contributions in years with high taxable income and reduced contributions in down years.
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As a result of the range, you will have more flexibility than you might have thought. Another benefit is that with each subsequent service year your range will widen. This makes it very simple to get the funding contribution you want while still keeping the plan compliant.
Combining Plan With a 401(k)
Not only are contributions higher with a cash balance plan, they can also be combined with a 401(k). We often refer to this as a “combo” plan. This allows you to increase the overall retirement funding even higher. But there is one restriction you should be aware of.
Traditional 401(k) plans (along with profit sharing contributions) will restrict profit-sharing contributions to 25% of W2 compensation or 20% for a sole proprietor. The employee deferral is still allowable based on the annual limits.
But when you combine a 401(k) plan with a cash balance plan, the business is limited to a 6% profit-sharing. Typically this is not a big issue because the cash balance plan contribution is so sizable it makes up for the lower profit-sharing contribution. But it is still an important consideration.
Combining plans is very popular and I would guess that 95% of our plans are combos. They just allow more funding flexibility along with higher contributions. In addition, there is minimal additional cost.
The #1 Tax Strategy
I have not mentioned it yet, but I think you are already aware that contributions are tax deductible. Cash balance plans plans are qualified plans just like 401(k) plans and other retirement deferrals. This means that contributions are tax deductible and then are taxed upon withdrawal (assuming a lower tax bracket at retirement).
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Upon retirement or plan termination, the investment funds can be rolled over into an IRA or 401(k) tax-free. You can annuitize a plan, but rollover usually makes most sense.
Ensure that you review your tax bracket with your CPA or tax advisor. The higher your tax rate the more these plans will make sense. There is a simple reason why many of our new plans are from people living in New York and California.
Age-Weighted Contribution Levels
The contributions under these plans are age-weighted and compensation based. This is a great benefit for most older business people but will be more challenging for younger people.
The older we get, the higher our income is and the more focused we get on retirement planning. This makes perfect sense. At a younger age, we think we will live forever, and we don’t typically have the funds to substantially contribute to retirement anyway.
Our typical client is 50-60 years old with an income of $500,000 plus. At this age, retirement planning is critical, along with any tax deferral strategies.
Most cash balance plans are set up with a retirement age of 62. But because these plans aim for a specified retirement balance at 62, we can make larger contributions as we get closer to that age. This is why our plan contributions are higher for 50-year-olds compared to 30 years olds.
What about the cons?
At this point, you should understand all the advantages and why these plans are great tax and retirement structures. But what about all the cons? Is there any catch?
Well, sort of. Pros and cons review is complete with a detailed analysis of the disadvantages—these plans best suit high-income business owners over 40 years of age.
Conservative Investment Options
Many people know that cash balance plans must be invested in conservative assets. Plans indeed have a stated interest rate credit, usually around 5%. So, the plan should aim for investment returns that mimic this stated crediting rate.
To offset lower cash balance investment returns, you can aggressively invest your 401k and IRA funds. You must sacrifice lower returns in the cash balance plan for a safe retirement plan and steady contributions.
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All things equal, higher investment returns will lead to lower future funding. Conversely, lower investment returns result in high funding levels going forward. The goal is to limit volatility and enjoy consistent funding levels. This analysis is helpful when considering the cash balance plan pros and cons.
I always tell clients who desire more speculative investments to do it in their IRAs or 401(k) plans. This is because 401(k)s establish a funding level upfront based on IRS established limits. Once the funds go into the plan account, the investment returns do not impact future plan funding.
Higher Plan Fees
401(k) plans are relatively low cost. They are free from some investment providers or run a few hundred dollars when a Form 5500 filing is required.
It is clear that these plans are more expensive than traditional 401(k) plans. But once you consider the large funding amounts, these plans become home runs for the person.
We establish these plans for solo business owners for just $990 (plus participant fees). Annual administration will run $2,000 to $2,500. So the plans clearly come with higher fee structures.
But with the average plan contribution of approx. $160,000 and marginal tax rates approaching 45% for many business owners, it only takes a little nudging to justify the plan costs.
But you should not establish these plans if you want to contribute $20,000 to $35,000. Stick with a 401(k) plan or possibly a SEP. That is, unless your income tax bracket is so high you need all the tax deductions you can get.
Plan Permanency
These plans are permanent in nature. This means that you can have the plan for a while.
The IRS says the plans should be open for at least a “few years.” So you should set up a plan with long-term intent.
These plans should be kept from being started and stopped at a whim. It is best if you plan on having the plans as an ongoing part of your company structure. If you have a plan open for just a few years and then decide to terminate it, you should not have an IRS issue as long as you had long-term intent and acted in good faith.
Many plans were terminated due to the Covid pandemic. But remember that you can continue your plan even if your income is lower. Consider amending the plan to reduce the pay credit or changing the formula. You do have options if your business is financially weak.
Non-Elective Contributions
One of the most significant advantages of 401(k) plans is that they are elective in nature. If you have a poor year financially, you can choose not to contribute. But have the option to max fund a plan in a good year. The point is that the contributions are elective and not mandatory.
But cash balance plan contributions are more complex. Unless a plan is substantially overfunded, you must make annual contributions.
Even though you have a funding range, you must at least make the minimum contribution, or you will be faced with an excise tax.
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These mandatory contributions often scare a lot of people. But once you take a close look, they typically aren’t that bad of a deal. Many people have excess funds in their bank account that was earned and taxed in previous years.
In addition, don’t forget that can fund the plan up to the date you file your business tax return (including extensions). So even though your business profits could be down, you might have the cash next year to make your contribution. Thankfully, minimum funding is normally not a deal breaker.
Complex to Administer
We all know that in life you don’t get something for nothing. These sizable contributions come with a few administrative headaches.
The plans are complex and must be carefully coordinated with your administrator, CPA and financial advisor. As a general rule, most financial advisors and CPAs don’t understand the plan structures.
You must realize that your tax problem has created some add’l work for you. But if you can make it through year one, you should be OK.
Cash Balance Plan Pros and Cons
Here are five steps to reviewing the cash balance plan pros and cons:
- Considering combining with other retirement structures
The good news is that cash balance plans can be used in conjunction with a 401(k) plan. Upwards of 90% of the plans we structure are combined with a 401(k). This structure allows clients to maximize funding in years with high income and also allow flexible funding in lower income years.
- Don’t forget the plan costs compared to other traditional options
Cash balance plans come with substantially higher cost structures. There is a set up fee and also annual administration costs. These fees are not a problem in most cases when you are funding $100k+ annually. However, they are too high if you just want to fund less than $40,000. Examine your funding requirements over the next several years to ensure that cost makes sense.
- Examine future funding levels
The biggest advantage with these plans include the significant contribution limits. You also have the option to fund for prior service that allows for front-loading. This is only applicable though in year one. No cash balance plan pros and cons review can be finalized without examining proper funding and a complete tax analysis.
- Discuss with CPA and financial advisor
Your CPA and financial planner know the most about your business and personal situation and can help guide you towards the best plan structure. We know that most advisors don’t understand these complex structures that much. As such, we often consult with CPA and other professionals to ensure that a plan structure is adequate for a client. But in any case, financial professionals are a good starting point for most people.
- Analyze timely funding
The IRS establishes operating guidelines for plan contributions. Because of the substantial funding levels, ensure you can fund before you file your income tax return. This might sound obvious, but it can require planning depending on business cash flows.
| Pros ✅ | Cons ❌ |
| Investment gains tax-deferred | Mandatory funding |
| Range for min/max contributions | Complex structure requirements |
| Significant tax deductions | High cost structure |
| Asset protection | Permanent plan design |
Bottom Line
When it comes to retirement planning, the ultimate goal is to incentivize business owners to save for retirement, while at the same time limiting them from taking advantage of plan loopholes. Cash balance plans can certainly help you achieve this goal.
Hopefully, you can weight the cash balance plan pros and cons so you can make the right decision for your business. We hope this article educated you on these plans and helped you determine if a plan is right for you!
