Cash Balance Plans are a retirement plan that was largely unknown for years, but has gained popularity in recent years, especially among high-income professionals, small business owners and self-employed individuals. This type of plan provides a fixed contribution by the employer that is calculated based on a percentage of an employee’s salary, and a guaranteed interest rate on that contribution.
A Cash Balance Plan is a type of qualified retirement plan with attributes of both a defined benefit and a defined contribution plan. A Cash Balance Plan combines the high contribution limits of a defined benefit plan with the portability and flexibility of a defined contribution plan. In a Cash Balance Plan, each participant has an account that grows annually in two ways: first, an employer contribution and second, an interest credit, which is guaranteed rather than dependent on the plan’s investment performance.
Unlike traditional defined benefit plans, which promise a specific monthly benefit amount in retirement, Cash Balance Plans seek to provide a specific account balance. Employers contribute to the Cash Balance Plan targeting this account balance. When the employee reaches retirement age, they can choose to take the account balance as a lump sum or as an annuity payment.
Cash Balance Plan High Contribution Limits
One of the main advantages of Cash Balance Plans is that they allow employers to make larger contributions on behalf of their employees than they would be able to with a 401k plan. This can be particularly beneficial for business owners who are nearing retirement and want to make larger contributions to their own retirement accounts while minimizing the tax burden on their business.
The employer contribution is determined by a formula specified in the plan document. It can be a percentage of pay or a flat dollar amount. A person’s age and 3-year average income also impact how much can be contributed to a Cash Balance Plan. Here’s two examples of how much could be contributed to a Cash Balance Plan:
Cash Balance Plan Key Benefits
An essential benefit of Cash Balance Plans is that employer contributions are 100% tax deductible. Cash Balance Plan contributions are an above-the-line tax deduction, which means they reduce business income dollar-for-dollar.
Another key benefit is that Cash Balance Plans are protected from creditors. Like all IRS-qualified retirement plans, Cash Balance Plans are protected by the anti-alienation provisions of ERISA, which states that “each pension plan shall provide that benefits provided under the plan may not be assigned or alienated.” This provision, which provides important protections to retirement assets, may be especially attractive to professionals working in litigious fields, like doctors.
Cash Balance Plans are easier to understand and administer than traditional defined benefit plans. This is because Cash Balance Plans provide a simple account balance that employees can track, rather than a complicated formula that determines their monthly benefit amount.
Cash Balance Plan - Ideal Candidate
Cash Balance Plans are not appropriate for everyone. Like other corporate plans, Cash Balance Plans have some set-up costs, ongoing administration costs, and contribution mandates. Really, Cash Balance Plans should be considered only by companies that are consistently profitable and have the means to cover these costs.
That being said, these are the perfect candidates for a Cash Balance Plan:
High-Income Professionals with Support Staff – Many professional businesses are organized around relatively well-paid professionals, with support staff. In these cases, a business can have a Cash Balance Plan for high-earning professionals, plus a 401(k)-only plan for all staff members.
Business Owners – Business owners typically focus on business growth and staff benefits to the detriment of their own retirement savings. A Cash Balance Plan may be the right retirement plan to increase the retirement savings of business owners.
Late Savers – Cash Balance Plans can also be a good option for business owners who are close to retirement age and may not have as much time to save for retirement as younger workers. This is because the contribution limits generally increase with age, allowing for potentially higher retirement savings rates by older business owners.
Business Buyout – Cash Balance Plans can be used fund or enhance a business buyout. If the acquiring partners are willing to forgo a portion of their income, this income could be allocated to a selling partner via a Cash Balance Plan. The entire buyout could be funded this way, or used to “sweeten” a buyout deal.
Cash Balance Plan Risks
There are some potential drawbacks to Cash Balance Plans that must be considered. One of the main disadvantages is that Cash Balance Plans may not be as flexible as other types of retirement plans, such as 401(k)s or individual retirement accounts (IRAs). This is because the contributions to the plan are determined by the employer, rather than the employee, so employees may not have as much control over their retirement savings. Changes can be made to contributions; however frequent changes are not permitted.
Additionally, Cash Balance Plans may not be suitable for all types of businesses, as they can be more expensive to administer than other types of retirement plans. This is because they require actuarial calculations to determine the interest rate and contribution amounts, which can be time-consuming and costly. Businesses should be profitable with robust margins.
It is important to note also that income taxes are deferred, not eliminated. As with other tax-deferred retirement accounts (e.g., IRA, 401(k) and SEP IRA accounts), the tax bill eventually comes due.
Like any other qualified Plan, a Cash Balance Plan is subject to nondiscrimination testing. 401(k) contributions are typically 5% to 7.5% of pay for staff if the owners or partners receive the maximum Cash Balance Plan contribution. The exact percentage required for employees depends on the number of employees included in the plan and the results of nondiscrimination testing.
Cash Balance Plans can be a valuable retirement planning tool for right company and person. Small business owners, self-employed individuals, highly compensated professionals, and older workers looking to maximize their retirement savings in a shorter period of time, should all consider a Cash Balance Plan. Reach out to Windham Wealth Management to see if a Cash Balance Plan is right for you and your business.