Disadvantages of Cash Balance Plans [+ IRS Red Flags❌]

We know how great cash balance plans can be. But what about the cash balance plan disadvantages?

One of the major benefits of cash balance plans is the tax-deductible contributions. Unlike a 401(k) plan, you must employ a 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 the defined benefit rules. These rules include minimum funding requirements and Code Section 415 DB limits.

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We’ll provide a quick summary and then get into the specifics.

Top Cash Balance Pension Plan Disadvantages:

  • Plan administration is expensive, although the plan benefits are high for the business owner.
  • An excise tax could be assessed if minimum contributions are not met. But the actuary can help monitor the risk and benefit accruals.
  • The plans are permanent in nature. You don’t have to have them forever, but you should at least have them open for at least several years.
  • As a general rule, they require mandatory annual contributions.

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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.

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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.

The hypothetical account

Each cash balance plan has a hypothetical account for each eligible employee. The plan administrator oversees the account reconciliation. The employer pays a pay credit based on a percentage of the employee’s salary plus a predetermined interest rate.

The company sets the interest credit rate, subject to IRS guidance. An employer can choose a fixed interest rate or variable. If they choose a variable rate, it’s tied to an index and varies along with the interest rate selected.

Freezing a pension plan may help reduce a plan sponsor’s long-term cost and the volatility of a plan sponsor’s financial obligations. However, once a pension plan is frozen, an employer and the frozen pension’s fiduciaries retain significant ongoing commitments and duties. Failure to comply with these obligations and responsibilities could have substantial adverse consequences for the plan sponsor, the frozen plan fiduciaries, plan participants, and their beneficiaries.

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.

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

Is a cash balance plan a qualified plan?

Yes, a cash balance plan is a qualified retirement plan under the Internal Revenue Code (IRC), meaning it must comply with certain rules and regulations set forth by the IRS to receive favorable tax treatment.

A qualified retirement plan is a retirement savings plan that meets specific requirements under the Internal Revenue Code (IRC) to receive favorable tax treatment. These plans are designed to help employees save for retirement by allowing contributions to be made on a tax-deferred basis, which means that contributions are not taxed until the account funds are withdrawn from the plan.

What is a qualified retirement plan?

To be considered a qualified plan, a cash balance plan must meet certain requirements, including:

  1. Non-discrimination: The plan must not discriminate in favor of highly compensated employees (HCEs) regarding plan participation and benefits.
  2. Contribution and benefit limits: The plan must comply with the annual contribution and benefit limits set forth by the IRS.
  3. Vesting: The plan must provide for the vesting of participant benefits over a certain period.
  4. Fiduciary duties: The plan sponsor and administrator must act as fiduciaries, meaning they must act in the best interests of the plan participants.
  5. Reporting and disclosure: The plan sponsor must comply with certain reporting and disclosure requirements, including providing annual plan information to participants and filing annual Form 5500 with the IRS.

By meeting these requirements, a cash balance plan can receive favorable tax treatment, including tax-deferred contributions and investment earnings, as well as potential tax deductions for plan contributions.

It is essential to note that the rules and regulations governing qualified plans, including cash balance plans, are complex and subject to change. Employers should work closely with their plan administrator and tax advisor to ensure their plan complies with all applicable rules and regulations.

Qualified retirement plans fall into two main categories: defined benefit plans and defined contribution plans.

  1. Defined benefit plans: These plans provide a fixed benefit to employees at retirement age, based on a formula that takes into account factors such as the employee’s years of service and salary history. Examples of defined benefit plans include pension plans and cash balance plans.
  2. Defined contribution plans: These plans allow employees to make contributions to the plan on a tax-deferred basis, and the contributions are invested in various investment vehicles, such as mutual funds or employer stock. Examples of defined contribution plans would include 401(k) plans, 403(b) plans, and profit-sharing plans.

What is a cash balance plan and how does it work?

A cash balance plan is technically a defined benefit pension plan that is becoming more common among employers to offer retirement benefits to their employees. Cash balance plans provide employees with a stated account balance rather than a promised monthly benefit, making the plan easier to understand and communicate to employees.

Cash balance plans are typically less expensive for employers to administer than traditional defined benefit plans and can provide employees with a more predictable retirement benefit than defined contribution plans. As such, they may be an attractive option for employers looking to offer retirement benefits to their employees.

For most cash balance plans, contributions must be made by the employer’s tax filing deadline, including extensions. For example, if the employer is a corporation and files its tax return on March 15th and obtains a six-month extension, the deadline to make contributions to the cash balance plan would be September 15th.

Why a plan can make sense

Contributing to a retirement plan is a wise financial decision that can help ensure a comfortable retirement. One of the main benefits of contributing to a retirement plan is the potential for tax-deferred growth.

Contributions made to a qualified retirement plan, such as a 401(k) or IRA, are made on a pre-tax basis, meaning that they reduce your taxable income for the year in which they are made. Additionally, the earnings on those contributions are not taxed until they are withdrawn from the plan. This can result in significant tax savings over the long-term, allowing you to keep more of your hard-earned money.

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.

In this post, we have discussed many of the plans’ disadvantages. We know these plans are home runs for the right clients.
A few people may ask why we wrote an article discussing these plans’ negatives instead of referencing the positives.

The reality is that many people know these plans are the number one tax and retirement strategy for many business owners. However, people often focus on the positives and don’t examine any plan disadvantages. For that reason, we felt it was necessary to make sure that we address these comments.

Of course, you know we’re big fans of these plans. But we also feel it’s important to review some of the highlights of these significant retirement structures. We want to ensure that people are educated before setting one up.

Paul Sundin

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