What are the Downsides of Cash Balance Plans? [+ IRS Red Flags]

We know how great cash balance plans can be. But what are the downsides of cash balance plans?

One of the major benefits of Cash Balance Plans is that they are tax-deductible. Unlike a 401(k) plan, however, participants cannot choose between an aggressive and conservative investment strategy. As such, it can be advantageous to use a Cash Balance Plan as an addition to your 401(k).

Cash Balance plans have some disadvantages. First, they are subject to many DB rules. These rules include minimum funding requirements and Code Section 415 DB limits.

Cash balance plan basics

The good news is that they are not subject to the traditional 401(k) contribution limits. You can also combine them with a 401(k) plan to get larger contributions.

These limits will reduce the amount of money distributed at retirement age. Consequently, cash balance plans can be costly for participants.

However, these drawbacks can be offset by the fact that most Cash Balance plans have federal insurance. Whether or not these plans are right for your particular situation is entirely up to you.

Another disadvantage of a Cash Balance Plan is that the amount of interest credited to the participant’s account is not affected by investment performance. The interest crediting rate of the cash balance plan is based on a fixed rate or on an index, such as the S&P 500. The frequency of interest crediting depends on the plan, but is usually annual.

What are the downsides of cash balance plans?

The required employer contribution is usually set at 4% or 5% per year. This means that if the employer does not meet the required contribution amount, the owner must make up the difference between the interest crediting rate and actual performance.

There are several disadvantages of Cash Balance plans, though. Because the benefits are higher for younger, short-service employees, and retirees, they are not ideal for most employers. Also, the conversion process is complicated and likely to favor certain participants.

In addition, the tax benefits of cash balance plans are limited to a single employer. As a result, most Cash Balance participants do not use their plan indefinitely. Fortunately, if you choose to use a Cash Balance plan, it may make sense to make the switch.

Any other disadvantages?

Cash balance plans are an ideal option for self-employed people. You can contribute up to $300,000 per year, depending on age and income. Another advantage of cash balance plans is that they can reduce taxable income and are often combined with a 401(k) plan.

These plans require an annual actuarial certification. You also get regular statements that explain how your funds are performing and whether or not you should take a lump sum or annuity.

Another disadvantage of cash balance plans is that you will have to spend a great deal of money on the administering the plan. The IRS wants cash balance plans to be in place for five to seven years, and asks that contributions be signed off annually.

Changing contributions requires a documented business reason. You must offer cash balance plans to at least 40 percent of your workforce, but no more. For most businesses, cash balance plans are better suited for smaller enterprises, medical and law firms.

Carefully consider plan structure

But before you sign up for a cash balance plan, take a look at a few of the cons:

  • The plan administrator must annually file a Form 5500 with a Schedule B.
  • The actuary must complete and sign the Schedule B calculations.
  • Along with other defined benefit plans, it is one of the more costly plans to administer.  Fees will typically start around $2,000 annually.
  • They are administratively complex plans and can often be difficult for employees and plan sponsors to understand.
  • The plans are not as flexible as a 401k plan.
  • They are not elective plans.  Even though a plan can be frozen or even terminated, a cash balance plan is established with annual contribution requirements.
  • An excise tax applies if the minimum contribution requirement is not satisfied.

Cash balance plans work very well under the right circumstances. But make sure that you are educated.  The pros and cons of cash balance plans may not always be clear. But once you clearly understand them you can make the proper decision as to whether a plan is right for you.

UpsideDownside
Significant ContributionsComplex Plan Structure
Large Tax Deductions5500 Filing Requirement
Tax-Deferred GrowthExpensive Fee Structure
Flexible DesignConservative Investments

Bottom line

Cash balance plans are beneficial to both employers and key employees. It is an excellent way for critical employees to boost their retirement savings significantly. Adding the cash balance plan to the old 401 (k) and profit-sharing plans increases total contributions by employer and employee, which benefits the employee.

The company also creates considerable tax savings; employer contributions are deductible for taxation. You can use the extra savings to fund other plans.

Paul Sundin

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