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Posted by Jim McClaflin, EA, NTPI Fellow, CTRC

All You Need to Know About the Cash Balance Plan

All You Need to Know About the Cash Balance Plan

Cash balance plans are defined benefit retirement savings plans that allow business owners to make large deductible contributions each year and build up deferred retirement savings. Although SEPs and 401(k) profit-sharing plans, such as defined contribution pension plans, limit total annual contributions to $58,000(this is indexed), annual contributions to a cash balance plan depends largely on the owner's age, and income exceeds $200,000.

Below is a list of some of the most frequently asked questions by business owners and their financial advisors, accountants, and lawyers to determine if a cash balance plan might be appropriate for meeting retirement and retirement goals—pension saving.

What is a cash balance plan, and how is it different from a traditional 401(k) plan?

As with a traditional 401(k) plan, a cash balance plan is a type of employer-sponsored retirement savings plan that is taxable—per the provisions of Section 401(a) of the Internal Revenue Code (IRC), qualifying retirement savings plans to provide for tax-deductible contributions, a deferred increase in plan investments, and creditor protection both for the employer and its employees.

A 401(k) plan on the other hand is a "defined contribution plan" in which each eligible participant can choose to withhold "deferral" amounts from their salary and contribute to their tax account in the plan. Deferred and the employer may, at its discretion, fund the amounts paid by the employer into the accounts of plan members. The retirement benefits paid to a participant in a 401(k) plan are not guaranteed but depend on the contributions made and the return on investment over the life of the member's retirement account.

A cash balance plan is a "defined benefit plan" in which the employer fully funds the plan. The plan clearly defines the contribution/benefit formula for members "traditionally" defined benefit plan expresses members' retirement benefits as monthly annuities payable at retirement, which can be confusing because the present value of the member's accrued benefits is not obvious. Although the IRS technically identifies a cash balance plan as a defined benefit plan because it clearly defines the contribution/benefit formula, it is generally seen as a "hybrid" between a defined benefit plan and a defined contributions plan because each participant benefit is expressed in the current account balance(similar to a 401(k) plan). In addition to receiving an annual contribution credit, each participant in a cash balance plan also receives an annual "fixed-rate credit." Thus, a participant's balance in a cash balance plan increases each year with the contribution credit and the fixed interest credit.

How are assets invested in a cash balance plan?

Unlike a 401(k) plan, the assets of a cash balance plan are not held in separate accounts for plan participants, and these participants cannot direct their investments. Instead, the assets of a cash balance plan are invested in a collected trust account held in the name of the plan and administered by the plan's investment advisor. Therefore, the cash balance trust serves as an investment vehicle funded annually by the employer and administered by the plan's investment advisor to pay benefits based on the "cash balance" monitored for each plan member.

The assets of the cash balance plan trust are prudently managed to 

  • Avoid the possibility of significant losses that affect the plan's ability to pay benefits when the time comes.

  • To prevent the depletion of the fund plan excessive (hence the fund's cash balance exceeds the increase in monitored "cash balances" for members, which could limit future deductible employer contributions to the plan and targets an annual return of around 5%.

How are the amounts in a cash balance plan (and how much) funded?

A significant difference between a 401(k) plan and a cash balance plan is a limit to the individual life insurance benefits in a cash balance plan. While a 401(k) plan can be funded up to the maximum annual Internal Revenue Service plan contribution limit of approximately $58,000 per year (and no limit to the number of years of funding for each participant), it must take at least ten years for maximum funding – the lifetime benefit limit for entrepreneurs in a cash balance scheme. For an entrepreneur who wishes to fund the lifetime benefit limit for a cash settlement plan, the owner's deductible annual contributions to the cash settlement plan are typically between $100,000 and $250,000 per year (depending on the owner's age) , business owner and income amount.

The amount that the employer must fund for the plan is reasonably constant from year to year. However, the employer has some funding flexibility in the form of an annual "funding range," as long as the employer has some funding flexibility, the plan remains "fully funded" for each year.

What Tax Benefits Do Cash Balance Plans Offer?

Since donations to a cash balance plan are tax-deductible for the sponsoring employer (or sole proprietor), there are significant tax savings from the first year of adopting the plan. For example, a contribution to the cash balance plan of $100,000 would instantly save $35,000 in federal taxes for a 35% tax entrepreneur. Tax savings would be higher for those living in income tax states. This contribution to the cash balance plan of $100,000 then increases on a tax-deferred basis to the cash balance plan trust account. Compare that to the increase in an after-tax amount of $65,000 ($100,000 - $35,000) paid into a regular brokerage account, which is taxed annually on earned dividends, interest, and capital gains.

Note that benefits accrued in a cash balance plan are subject to income tax when withdrawn during retirement. Therefore, part of maximizing the tax benefits of maintaining a cash balance plan is to assess your future tax status.

What is the maximum lifetime limit for a cash balance plan?

In an ideal scenario, for an entrepreneur who funds a cash balance plan up to the maximum IRS fund limit, the funding would typically take place for 10 to 12 years, ending in 62 years or more. And the "cash balance" when the lifetime funding limit is reached would be approximately $2.9 million. This $2.9 million amount is a combination of principal (annual deductible contributions) and interest (annual fixed-rate loans). It would be discounted for an entrepreneur whose life limit is reached before the age of 62.

Can an employer keep a cash balance plan and a 401(k) plan?

Yes. Several employers who keep a cash balance plan also keep a 401(k) plan. In some situations, this is done to add additional retirement savings for employers. Also, a 401(k) plan is maintained to help employ and retain employees when the sponsoring entity has employees.

If the sponsor of a cash balance plan has employees, what is the funding obligation for the employees?

A cash balance plan can use a qualified age requirement of up to 21 years and a qualified waiting period of up to one year for new employees (when joining the plan on January 1 or after July 1). Although some employees may be excluded from a cash balance plan, the plan should generally "cover" at least 40% of all owners + employees who have met the qualified requirements (but no less than two, if at least two qualify for eligibility). Contributions to a cash balance plan must meet the requirements of the IRS "non-discrimination" test. While eligible employees tend to be younger than owners, the test is based on age, which allows for a lower contribution rate for employees than owners. The IRS rules on non-discrimination determine the employee contribution requirement; it is not based on a fixed amount or percentage of contribution but rather on the amount or percentage needed to pass the test. Additionally, if the employer maintains a 401(k) incentive plan with the cash balance plan (which is usually the case), employer contributions to both plans are added for testing purposes. In an ideal scenario where there is a significant age difference between the owner(s) and employees, as a rule, employees will need a total employer contribution of 9% of their total salary (2% as real balance) and 7% for profit-sharing.

Can A Cash Balance Plan Use A Consolidation Schedule?

Yes. Most cash balance plans use a three-year vesting program, in which an employee is entitled to 0% until they have completed three years of service with the employer and the employee is invested 100% on time; the vesting year is defined as a plan year during which the employee completes at least 1000 (one thousand) hours of service. With a three-year consolidation plan, if an employee terminates the employment relationship before completing the three years of consolidation service, his total balance will be "lost" and used to offset/reduce the contribution charges by cash from the future employer. If the employer wishes, you can certainly use a rewards program that is less than three years old. (Note that consolidation is based on the total number of years of service with the employer; a "continuous" consolidation program does not apply to each year's cash contribution.)

When is the deadline for establishing a new cash balance plan?

Before 2020, a new cash balance plan should be adopted by the last day of the initial year of the plan. From 2020, the SECURE act allowed entrepreneurs to adopt a cash balance plan during the entity's tax reporting period (including extensions) for the first year of the plan. It usually takes a few weeks to prepare plan documents, create the plan trust account, calculate Year 1 contributions, and fund Year 1 contributions to the trust account before the tax return expires. In practice, entrepreneurs are advised to start working with a professional at least one month before the entity's tax filing deadline for the first year of the scheme.



Jim McClaflin, EA, NTPI Fellow, CTRC
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