Cash balance plans are becoming increasingly popular and they are great plans for the self-employed. But they leave many people asking the question – what is a cash balance plan? In this post we answer the question.
Many business owners are searching for significant tax deductions and a way to accelerate their retirement savings. Cash balance plans solve these two problems.
So what is a cash balance plan?
A cash balance plan is a type of qualified retirement plan that is approved by the IRS. It is technically a defined benefit plan meaning it is considered a type of pension plan in which an employee’s pension payments are calculated based on their compensation, age, length of service, and other potential employment factors.
But in contrast to traditional defined benefit plans, they show benefits as a stated dollar amount. For this reason they are often called hybrid plans because they have characteristics of both defined contribution plans and defined benefit plans.
With a cash balance plan, each of the participants has an account balance that grows annually. This growth is from employer contributions and an interest “credit.”
They are subject to nondiscrimination testing just like other qualified plans. Employers who anticipate making maximum owner contributions should anticipate contributions of 5% to 7.5% for staff employees.
Employers make annual contributions for employees who are covered under the plan. Employee contributions ultimately depend on the number of employees who are included in the plan and the final results of nondiscrimination testing.
Vested account balances can be paid in a lump sum distribution or as an annuity. Participants have the ability to roll a lump sum distribution into an IRA or another qualified retirement plan if desired.
Cash balance contributions can change, but there are some restrictions and limitations. The plans can be amended to allow different contribution levels. Any reductions in contributions should be made before an employee works 1,000 hours during a given plan year.
The plan sponsor also has the ability to freeze or terminate a plan. Some plans offer additional benefits such as disability benefits, cost of living adjustments, spousal protections, etc.
Important considerations with cash balance plans
Be sure to read the fine print of each individual cash balance plan document, as they have some critical details. A few things worth noting are:
- Contributions to the plan must be made by the employer by the tax due date or the due date extension in order to take advantage of tax benefits.
- The required minimum funding contributions must be made within at least 8 ½ months following the plan year end.
- As an employee, your rate of return is the “interest charges” that are contributed by the employer and are pre-determined in the plan documents.
- For employers, cash balance plans must be insured by a “Pension Benefit Guaranty Corporation: (PBGC), adding to the cost of offering this plan to your employees.
- Cash balance plan contributions may differ from each employee. There is no requirement for the employer to contribute the same amount to each employee. The contribution amounts are determined based on compensation, job responsibilities, length of time with company, etc.
Let’s look at the details
So now that you understand the basics, let’s take a look at some of the specific details. You may be familiar with a retirement vehicle often offered by employers called a pension plan. A pension plan is a vehicle designated for retirement that your employer would offer qualified employees, guaranteeing them a certain amount of income per month upon retirement.
Like a pension plan, a cash balance plan is a retirement vehicle offered by employers to qualified employees of a company. The employer contributes a set percentage of the employee’s yearly compensation plus an interest credit to an account designated for the employee’s retirement.
As stated before, the plan receives pre-determined additional contributions on the employer’s part based off the amount contributed as a percentage of the employee’s salary.
Rather than relying on a rate of return from the stock market, the employer guarantees these interest charges as a form of return on investment for the employee. This rate of return is defined in the plan documents but usually is anywhere between 4% – 5% in most cases. Any annual interest credit allowed under the plan is guaranteed and is not dependent on investment performance of the plan’s assets. Interest credits are often tied to established interest rate indexes, such as the 30-year Treasury Rate.
Typical rates in recent years have been 3% to 5%. As a result of recent changes in the law, there are many interest credit rate options, including utilizing actual rate of return on plan assets or a fixed amount.
The cash balance plan works great for sole proprietors, S-corps and C-corps. It also works similarly for a partnership. Contributions for non-partner employees are taken on the partnership tax return (Form 1065). However, contributions made on behalf of partners are deducted the partner’s personal or corporate tax returns. Partner contributions should be reflected on Schedule K-1.
The partnership operating agreement must allow this method of allocation. But when partnerships adopt Cash Balance plans they typically want special allocations that differ from allocations proportionally to ownership percentages. The partnership agreement or internal policy should ensure that each and every partner is allocated the proper amount.
How much can be contributed to a cash balance plan?
Contributions are determined by a formula specified within the plan document. It is often a percentage of pay or even a flat dollar amount. Take a look at the table below and you can see amounts that can be contributed for Cash Balance Plans and 401k plans. In practice, the amounts below will vary depending on annual compensation:
What is a cash balance plan: So how are the funds invested?
The plan assets are pooled together and typically invested by an investment manager. This is at the direction of the trustee. If the plan’s investment income and gains exceed the guaranteed rate, the excess will be utilized by the employer to reduce future contributions. However, this will not impact any amount that is credited to the participants’ accounts.
Cash balance plans are typically invested in the stock market, like a 401(k) plan, and managed professionally by a sponsored investment firm. The investments are actively managed and are not chosen by each individual employee. An actively managed account is an investment account that is managed on a regular basis by an investment professional, based off the client’s (in this case the employer) risk tolerance and funding goals.
But if the plan’s investment returns are less than the guaranteed rate, the employer will need to increase future contributions. This difference is generally spread out over several years. The plan sponsor and trustee have a variety of investment options to achieve the interest credit rate. What is a cash balance plan if it does not have quality investment options?
What are the pros and cons
As it is with nearly all retirement benefit plans, cash balance plans has its pros and cons.
- They are not subject to the traditional $53,000 contribution limits.
- Ability to combine the benefits of multiple retirement accounts along with your cash balance plan, such as a 401(k) and IRA’s.
- Ability to withdraw funds at any age if withdrawn as an entire lump sum.
- Higher contribution limits in many cases as compared to other defined benefit plans.
- Steady and conservative growth are more likely, without the volatility of the ups and downs of the stock market. (the growth is the interest charges pre-determined in the plan documents, and not based solely upon the stock market)
- Cash balance plans can be used in combination with a traditional 401(k) plan and profit sharing plan.
- Generally, cash balance plans provide a traditionally more modest growth rate (which is pre-determined in the plan document).
- They are insured by a “Pension Benefit Guaranty Corporation” (PBGC). However, in order for the plan to be insured by a PBGC, the plan needs to have at least 26 plan participants.
- If you are a company owner that offers this plan, you have the option to use the tax deductions on your personal taxes or the company taxes.
- Unlike traditional 401(k) plans, cash balance plans do not have a select set of investment options to choose form. The investments are professionally managed, leaving you less direct control on investments.
- Many people opposed to cash balance plans are groups who do not trust the employers underwriting capabilities. This opens up the risk of the company not being able to pay out the amount of money originally promised in the plan document.
- While the plan is insured by a PBGC, this also means there are insurance premium costs.
- The plan requires actuarial services adding to the costs to offer the plan to employees.
- The plan often has restrictions on the lump sum payment options
By weighing the pros and cons, you may determine if a cash balance plan is right for you as an employer, or as an employee with the option to participate.
What is a cash balance plan contribution limit?
All retirement vehicles have some form of contribution limit in most cases, each type of retirement vehicle offering different contribution limits or benefits.
Cash balance plans contribution limits are much higher than most other defined benefit plans. The contribution limits are dependent upon the employees age. The older the employee is, the more they are able to contribute. The younger the employee, the less they are able to contribute. This allows for owner employees who start a small business, to fund the growth of the business in the beginning years and later begin contributing to their retirement more aggressively after the business is more saturated.
Each plan contribution limits will differ some, so there is not an exact number stated as to how much you are able to contribute. Each contribution limit will be defined very clearly in the plan documents and vary for each situation.
For a broader response, cash balance plans allow you to contribute much more than the regular $53,000 yearly limit of a 401(k) plan, and the $5,500 of a typical IRA account (as of the time of this writing). In either case, you will still get a tax deduction.
What is a cash balance plan: So what type of companies are best suited?
The ability to contribute a larger amount per year based on each individual’s age, makes cash balance plans very attractive for any small business owner.
As previously mentioned, many small business owners wish to re-invest as much of the business income back into the growth of their company, leaving them with less funds to contribute toward retirement. As the business matures, the small business owners are then able to contribute substantial amounts of money toward their cash balance plan. This allows them to “catch-up” on their retirement planning.
Others who may benefit from cash balance plans are:
- Companies with large income streams and the ability to contribute the minimums to a cash balance plan, along with the interest charges laid out in the plan.
- Company executives who have owner interest in a company and want to combine the benefits of multiple retirement accounts for retirement (401(k), IRA’s, other defined-benefit plans).
- Companies wanting to offer an attractive benefit to vital company executives who have a key role in the company.
Regardless of your current employer retirement benefits, it is always a clever idea to take advantage of what is offered. If your employer offers a cash balance plan, be sure to read the fine print and use the benefits offered therein to your advantage.
So what is a cash balance plan? Depending on your situation, it might be the best retirement plan for you.