What is a Cash Balance Plan? Your Top Questions Answered

Bottom Line Up Front

• A Cash Balance Plan is a type of Defined Benefit Plan that allows large tax-deductible retirement contributions that are tax-deferred and protected from creditors.
• These plans are best for self-employed or small business owners who are at least 50 years old and are looking to significantly increase their retirement contributions and minimize their taxes.
• Please consult your financial advisor and a third-party administrator (TPA) who is typically an actuary specializing in Defined Benefit and Cash Balance Plans.

What is a Cash Balance Plan?

A Cash Balance Plan is a type of Defined Benefit Pension Plan IRS § 401(a) that is often used by small business owners. It allows for significant tax-deductible contributions each year and the accumulation of retirement assets which are both tax-deferred and protected from creditors. As such, it is a great tax planning, asset accumulation, and asset protection vehicle.

What are the benefits of a Cash Balance Plan?

Most business owners adopt a Cash Balance Plan to accelerate their retirement savings and to take advantage of the tax deduction benefits. These plans have a higher annual contribution limit than 401(k) Profit Sharing Plans. Below is a table showing the potential annual retirement savings and tax deferral amounts.

What is the difference between a Cash Balance Plan and a 401(k) Plan?

While both are considered qualified plans under IRS § 401, the key difference is that a Cash Balance Plan is a Defined Benefit plan (e.g., the benefit to be received in retirement is defined – not the contribution by the employer) while the 401(k) is a Defined Contribution plan (e.g., the employee and/or employee contribution is defined – not the amount they will receive in retirement).

In short, the employee bears any investment risk in a 401(k) plan – so, in periods of excess market returns, they will receive higher benefits and vice versa.

Additionally, while most participants will choose a lump sum at retirement, the Cash Balance must offer a lifetime annuity and most such plans are covered by the Pension Benefit Guaranty Corporation (the “PBGC”) which provides insurance for such benefits.

Can I have a Cash Balance Plan if I already have a 401(k) or IRA?

Yes – Cash Balance Plans are designed to allow for significantly higher tax-deductible contributions than a 401(k) Plan or IRA and are meant to be an additional retirement plan rather than a replacement plan. Think of it as stacking another plan on top of your 401(k) or IRA.

Who is the ideal candidate for a Cash Balance Plan?

A Cash Balance Plan may be a good fit for you and your business if you fit into the following:

• Your company has fewer than 10 employees
• The owners are generally older than the employees
• The owners have higher earned & predictable income

How does a Cash Balance Plan work?

Cash Balance plans provide each participant a “pay credit” every year. The pay credit is the amount the employer contributes annually on behalf of the owners and the participants. It can be defined as a percentage of income, a flat dollar amount, or a combination of both. For example, $1,000 annually per participant or 3% of a participant’s annual income. The contribution can be different for employees and owners as long as it passes compliance testing. Each company’s funding formula varies based on the employer’s goals and their employees’ demographics.

Additionally, these accounts are also credited a guaranteed rate of interest on the accumulated contributions each year called interest credit. This credit is normally a fixed rate such as 5% or tied to an index like the 30-year treasury yield. Both the pay credit and interest credit are defined in your plan document.

Can I set up a Cash Balance Plan if I’m self-employed?

Yes – you can establish a Cash Balance Plan or any qualified retirement plan.

What is the maximum amount I can get from a Cash Balance Plan?

As noted above, a Cash Balance Plan is a defined benefit plan so there are limits on the maximum benefit that may be paid. IRS § 415(b) limits the benefit that may be paid from a defined benefit plan ($265,000 annually at Normal Retirement Date for 2023 and indexed). This amount is reduced if the participant has less than 10 years of participation in the plan as well as for retirement before the Normal Retirement Date. Assuming that the participant is at least age 62 with a minimum of 10 years of participation in the plan, the maximum lifetime lump sum payable from a Cash Balance plan is approximately $3.4 million for 2023 (indexed based on interest rates, mortality, etc.).

How much can I contribute to a Cash Balance Plan?

The maximum amount you can contribute is limited by your compensation and age. For example, if you earn at least $330,000 per year this ranges from approximately $140,000 if you’re 40 years old to $300,000 if you’re 60 years old.

Does a Cash Balance Plan limit how much I can contribute to my 401(k) Plan?

The tax deduction limit for the combined plans (Cash Balance & 401k) is greater than 25% of covered payroll and the minimum required funding for the Cash Balance Plan. However, if employer contributions to the 401(k) Plan do not exceed 6.0% of covered payroll, the 25% limit does not apply. If the Cash Balance Plan is covered by the PBGC, higher contribution limits will apply.

How is my Cash Balance benefit determined?

A Cash Balance plan has three (3) key components which determine the benefit:

1. Pay Credits – the plan will define a credit (normally a % of compensation) that is credited to the participant’s account (normally on an annual basis).
2. Interest Credits – the plan will define an interest crediting rate – usually a fixed rate such as 5.0% but it may vary based on the 30-year US Treasury rate or based on an index such as the S&P 500. The interest credit frequency is defined by the plan but is normally credited annually.
3. Actuarial Equivalence – the plan defines how the account balance may be converted into various benefit forms such as a lump sum or an annuity upon the retirement or termination of the participant or the termination of the plan.

Can a Cash Balance Plan use a vesting schedule?

Absolutely. A Cash Balance plan may use a vesting schedule of no more than three (3) years. While most plans will use a “cliff” vesting schedule such that an employee must complete three years of vesting service to be 100% vested (fully entitled to the benefit), an employer may choose a “graded” schedule with some vesting amount at lower service levels. When an employee terminates employment before completing the required vesting service for 100% vesting, any non-vested amount is “forfeited” and may be used to offset or reduce the employer’s future contributions.

How long must I maintain a Cash Balance Plan?

All qualified retirement plans, including Cash Balance plans, must be intended to be “permanent” at inception. As such, we recommend that a plan be maintained for at least five (5) years to meet the permanency requirement, it is certainly possible to terminate sooner and there is no restriction on doing so. However, many plans including Cash Balance plans will be terminated for a variety of circumstances that could not have been foreseen at the inception of the plan (e.g., sale of the business, material revenue change, health changes, etc.).

What are the advantages and disadvantages of a Cash Balance Plan?

The advantages are well known and often highlighted but it is important to remember that large tax-deductible contributions and flexible plan design do carry the disadvantage of minimum required contributions.  

How do I invest my Cash Balance Plan assets?

It is important to note that, unlike a 401(k) Plan, a Cash Balance plan holds all assets in one pooled account and these assets are invested by the employer and not the participants. The plan sponsor should work with their investment advisor to determine an appropriate investment policy given the plan’s defined interest crediting method and the plan sponsor’s tolerance for contribution volatility. 

Normally, these assets are invested in a conservative to moderate asset allocation model (target returns of 3% to 7% per year while minimizing downside risk) – this prevents large swings in required contributions and prevents the plan from becoming overfunded such that they exceed the maximum allowable benefit payout.

Is a Cash Balance Plan Right for Me?

If you are self-employed or own a business with stable or accelerating income, are at least 35 years old, and want to significantly increase your retirement contribution but are limited by your existing plan’s threshold. These plans are very common for professional services firms, but they work for any business with stable or accelerating income. 

There are a lot of factors to consider when adding a new retirement plan as a business owner. An actuary that specializes in retirement plans, specifically defined benefit and cash balance plans, can help you understand if a Cash Balance plan is right for you based on your situation and goals. 

What is the deadline to establish a new Cash Balance Plan?

With the passage of the SECURE Act, the deadline to establish a plan is the business’s tax filing deadline (including extensions). The plan must be both executed and funded by that deadline so it is important to begin working with an actuary and your financial professional well in advance of that date to ensure you can meet the deadline.

What’s the process to set up a Cash Balance Plan?

To establish a Cash Balance Plan, you will need to work with an actuary to design a plan that meets your specific financial goals (e.g., the desired level of tax-deductible contributions, targeting benefits to the appropriate employees). Beyond that, you will want to work with your financial advisor to establish the necessary trust for the investments of the plan. The process of plan design and opening of the trust will often take four to six weeks so we encourage you to leave sufficient time to ensure an optimal outcome.

If you have questions on how to align your business needs with your personal goals, check out our form below. If you would like to get a free retirement plan review, you can reach out to us directly here.