There are two main types of pension plans: defined benefit plans and defined contribution plans. Defined benefit plans offer a specific retirement benefit for each eligible employee, while defined contribution plans specify the amount of contributions to be made by the employer towards the employee’s retirement account.

In a defined contribution plan, the actual retirement benefits provided to an employee depend on the amount of contributions made as well as the gains or losses of the account. A cash balance plan is a defined benefit plan that defines the benefit in terms similar to a defined contribution plan. In other words, a cash balance plan defines the promised benefit in terms of a stated account balance.

A cash balance plan is a retirement plan where the participant’s account is credited annually with a “pay credit” (such as 5% of their compensation from their employer) and an “interest credit” (either a fixed or variable rate linked to an index like the one-year treasury bill rate).

The value of the plan’s investments does not directly impact the benefit amounts promised to participants, meaning investment risks are borne solely by the employer. When a participant becomes entitled to receive benefits under a cash balance plan, they receive an account balance that defines the benefits.

For example, if a participant has an account balance of $100,000 when they turn 65, they would have the right to an annuity based on that balance. This annuity might be approximately $8,500 per year for life. However, many cash balance plans offer the option for a participant to choose a lump sum benefit instead (with consent from their spouse) equal to the $100,000 account balance.

If a participant receives a lump sum distribution, that distribution can generally be rolled over into an IRA or another employer’s plan if the plan accepts rollovers. The benefits in most cash balance plans, as in most traditional defined benefit plans, are protected within certain limitations by federal insurance provided through the Pension Benefit Guaranty Corporation.

There is no specific time period required for your retirement plan to be open, but the IRS considers these plans to be permanent. The agency assumes that the plans will operate indefinitely or at least for a few years, although it doesn’t define what “a few years” means.

In general, the IRS hasn’t questioned plan terminations that occur more than 10 years after inception, and employers that terminate a plan within 5-10 years usually don’t have problems. However, if you want to terminate your plan, you should make sure it’s a business necessity.

This would typically involve lower business profits, a change in ownership, or an issue that restricts funding the plan. The IRS has even accepted a company adopting a different retirement plan as a valid reason to terminate.

Your contributions to the plan will be determined by our actuary, and they will depend on your age and W2 income, or business profit if you are a sole proprietor. For each year after the plan is set up, you will typically be given a range of contribution amounts to choose from. You can decide how much you want to contribute and let us know.

If you choose to pay on the low end, it could result in a slightly higher range for the following years, and if you pay on the higher end, it could result in a slightly lower range. However, you have a lot of control over your W2, so you can adjust your contributions to fit your needs.

We will contact you in the fall to see how your year is going and what you anticipate your W2 to be. This way, we can plan accordingly before the year ends. If you have employees, we will examine their payroll and determine a contribution to be made on their behalf.

Most plan administrators use a 5% rate in today’s market, which is considered a safe harbor rate. This rate is beneficial when cross-testing a plan with employees. However, you can use other rates like the 30-year treasury bond or actual return.

The actual rate of return can eliminate many of the over-funding or under-funding issues that create challenges. This rate is mostly used for larger plans with higher plan assets and many employees.

At the end of the day, using the 5% rate offers testing benefits and does not require the actuary to recalculate the rate each year. It also allows for larger contributions, as it will be higher than the 30-year treasury rate.

The primary reason for these plans is tax deferral, so small plans can allow larger contributions for the business owner. Moreover, the higher 5% rate creates a wider funding range, which helps employers fund at higher levels if they choose.

In summary, the 5% rate is used for smaller plans (under 20 employees) as it offers simplicity and better funding. However, for larger plans, you can consider other options that can limit plan over-funding and create consistent funding levels.

We can usually run an illustration in 1-2 business days. All we need is the following:

Owner age or birth date

Desired total retirement contribution

Business net profit

Number of full-time employees (if any)

If you have an employee census that details employee W2 compensation, birth date, hire date, termination date that would help.

Advantages

Substantial Contributions

Cash balance plans allow for larger contributions than any other retirement structure, making them a popular choice for those looking to contribute $100,000 or more annually. Unlike 401(k) plans, cash balance plans do not establish annual contribution limits, as they are a type of defined benefit plan that aims to have a substantial, identified amount at retirement. Annual contributions can be as high as $300,000, subject to income, compensation, and age.

Funding Range & Flexibility

Contrary to popular belief, cash balance plan contributions are not fixed and can be structured as fixed or selected contributions. Most plans offer a flexible funding range that identifies a minimum, target, and maximum funding level. This range allows for more significant plan contributions in years with high taxable income and reduced contributions in down years. With each subsequent service year, the range widens, making it easy to get the funding contribution you need while keeping the plan compliant.

Combining Plan With a 401(k)

Cash balance plans can also be combined with a 401(k), which is called a combo plan. This combination allows for even higher overall retirement funding, but there is one restriction to keep in mind. Traditional 401(k) plans, along with profit sharing contributions, limit profit-sharing contributions to 25% of W2 compensation or 20% for a sole proprietor. While the employee deferral is still allowable based on annual limits, the business is limited to a 6% profit-sharing when combining a 401(k) plan with a cash balance plan. However, this limitation is generally not an issue since the cash balance plan contribution is so sizable that it makes up for the lower profit-sharing contribution.

The #1 Tax Strategy

Cash balance plans are qualified plans like 401(k) plans and other retirement deferrals, making contributions tax deductible. Upon retirement or plan termination, the investment funds can be rolled over into an IRA or 401(k) tax-free. While you can annuitize a plan, rolling over usually makes more sense. It is important to review your tax bracket with your CPA or tax advisor, as the higher your tax rate, the more cash balance plans will make sense. These plans are particularly popular with people living in high-tax states like New York and California.

Age-Weighted Contribution Levels

Cash balance plan contributions are age-weighted and compensation-based, meaning that older business people tend to benefit from them more than younger people. As we get older, our income typically increases, and we become more focused on retirement planning. 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 plan contributions are higher for 50-year-olds compared to 30-year-olds.

Disadvantages

Conservative Investment Options

Many people are aware that cash balance plans require conservative investments. Such plans usually have a stated interest rate credit of around 5%. It is essential to aim for investment returns that match this interest rate credit.

To offset lower cash balance investment returns, it is possible to invest 401k and IRA funds aggressively. It may be better to accept lower returns in the cash balance plan and opt for a safe retirement plan with steady contributions.

Higher investment returns will lead to lower future funding, while lower investment returns will result in high funding levels going forward. The aim is to limit volatility and enjoy consistent funding levels. This analysis is useful when considering the pros and cons of the cash balance plan.

I often advise clients who desire more speculative investments to do so in their IRAs or 401(k) plans. 401(k) plans establish a funding level upfront based on IRS-established limits. The investment returns do not affect plan funding once the funds are deposited into the plan account.

Higher Plan Fees

401(k) plans are relatively low-cost and are available for free from some investment providers or cost a few hundred dollars when a Form 5500 filing is required.

However, these plans are more expensive than traditional 401(k) plans. But, when you consider the large funding amounts, these plans are a home run.

We set up these plans for solo business owners for just $990 (plus participant fees). Annual administration costs will range from $2,000 to $2,500, so the plans have higher fee structures.

But with the average plan contribution of approximately $160,000 and marginal tax rates approaching 45% for many business owners, it only takes a little persuasion to justify the plan’s costs.

However, it would be best not to establish these plans if you want to contribute $20,000 to $35,000. Instead, stick with a 401(k) plan or a SEP, unless your income tax bracket is so high that you need all the tax deductions you can get.

Plan Permanency

These plans are permanent, meaning you can have them for a while.

The IRS requires the plans to be open for at least a few years, so it is best to set them up with a long-term intent.

Avoid starting and stopping the plans on a whim. Having the plans as an ongoing part of your company structure is best. 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-19 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 needs to be financially strong.

Non-Elective Contributions

One of the significant advantages of 401(k) plans is that they are elective. If you have a poor financial year, you can choose not to contribute. However, you have the option to fund a plan at the maximum in a good year. The contributions are elective and not mandatory.

However, 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 make at least the minimum contribution or face an excise tax.

These mandatory contributions can be quite daunting. But, once you take a closer look, they usually are not that bad of a deal. Many people have excess funds in their bank accounts that were earned and taxed in previous years.

Moreover, remember that you 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 contribute. Thankfully, minimum funding usually is not a deal-breaker.

Complex to Administer

We all know that in life, you do not get something for nothing. These significant contributions come with a few administrative headaches. The plans are complex and must be carefully coordinated with your administrator, CPA, and financial advisor. Generally, most financial advisors and CPAs do not understand the plan structures.