Business owners and high-income professionals who have maxed out their retirement plans may wonder how to save more for retirement while also lowering taxable income in the year. Cash balance plans might help.
Simply put, cash balance plans are defined benefit plans that may allow you to save substantially more for retirement on a tax-deferred basis. They’re complex, however, and require specialized tax and financial knowledge. Here are some important things to know about cash balance plans.
How Do Cash Balance Plans Work?
Cash balance plans have been around for decades and have gained popularity among privately-held businesses, professional practices, and entrepreneurs in recent years.
In general, these plans allow owners to contribute much more to retirement each year than traditional defined contribution (employee-sponsored) plans. If you’ve fallen behind on saving for retirement or simply want to grow your tax-advantaged retirement assets, a cash balance plan could allow you to save more each year.
These plans are worth considering for business owners who generate strong annual profits, have predictable cash flow, and want to increase contributions to their retirement savings.
What Is a Cash Balance Plan?
Cash balance plans are a type of defined benefit plan1. Each employee has an account balance with the strategy to increase it each year, making it easier to understand than a traditional pension plan.
Account balances generally include an annual employer contribution (sometimes referred to as a “pay credit”) and an interest credit (either a predetermined amount or based on a set formula).
As with a 401(k) plan, an employee could see their account balance grow each year. However, with a cash balance plan, the employer bears the investment risk and responsibility. When the employee retires or separates from service, any vested account balances are typically paid out as a lump sum or transferred into an IRA or another qualified retirement plan.
Higher Contribution Limits
An attractive benefit for some owners is the ability to increase tax-deferred retirement contributions. Because cash balance plans are defined benefit plans, annual contributions are based on actuarial values2.
For that reason, there is often no set contribution limit. Instead, your age, income, years until retirement, plan design, and actuarial assumptions help determine your total contribution.
Owners who are closer to retirement may be able to save hundreds of thousands of dollars per year, while younger business owners may have lower contribution limits.
Keep in mind that there are IRS limits3. For that reason, it’s a good strategy to work with financial and tax professionals when evaluating your options.
Benefits of Cash Balance Plans
Here are some more details about the benefits and considerations for cash balance plans including increased contribution limits, tax benefits, cash flow considerations, and administration costs.
Increased Retirement Contributions
This is a considerable benefit. By design, cash balance plans allow owners to increase their annual tax-deferred contributions. If you’re behind on retirement savings, or you started your business (and retirement plan) later in life, a cash balance plan may allow you to catch up.
Tax Benefits
Contributions made to a cash balance plan are tax-deductible to the employer. As such, you may be able to better manage your current taxable income while also funding a larger retirement account.
Cash Flow Considerations
Keep in mind that you need sufficient cash flow to make annual contributions. Because cash balance plans are funded by the employer (versus employee salary deferrals), employers must have the cash available to fund the plan each year. Business owners should plan to continue making contributions for the foreseeable future. Failed funding could result in IRS penalties of 10% of the unfunded amount3.
Employee Benefits
It is permissible for a cash balance plan to exclusively benefit owners and select employees, but your business may require a plan that encompasses all employees.
When used in conjunction with a traditional 401(k) plan, businesses might offer a competitive benefits package while also providing additional retirement savings for owners.
401(k) Plus Cash Balance Plans
Some businesses choose to have both a cash balance plan and a 401(k) plan. By having both, business owners might provide attractive benefits for employees while also increasing the contributions they make to their own retirement savings.
Employees may make salary deferral contributions to a 401(k) plan. Some businesses also offer matching contributions, as well as profit-sharing contributions. Additionally, business owners may make additional tax-deductible contributions through a cash balance plan.
Annual Contributions
Cash balance plans are funded differently when compared to traditional profit-sharing plans. While profit-sharing plans may fluctuate based on business performance, cash balance plans typically require annual contributions. These contributions are calculated by an enrolled actuary and are based on multiple factors. Business owners should be prepared to make annual contributions for the life of the plan.
Administrative Costs
In addition to required annual contributions, cash balance plans also require annual actuarial valuations. This means more administrative work and costs.
You need a retirement plan administrator to manage the day-to-day activities. However, you should expect higher administrative fees with a cash balance plan compared to basic retirement plans.
Should You Establish a Cash Balance Plan?
If your business is profitable and you have plans to retire in the next 10 to 20 years, a cash balance plan may be worth considering. While contribution limits vary by individual, age, and income, some business owners are allowed to save a significant amount each year. Cash balance plans may allow owners to lower their taxable income while also saving for retirement. If you have the necessary requirements, your business could establish a cash balance plan to manage your contributions and taxable income for the upcoming year.
Important Disclosures:
This material was created for educational and informational purposes only and is not intended as ERISA, tax, legal or investment advice. If you are seeking investment advice specific to your needs, such advice services must be obtained on your own separate from this educational material.
This article was prepared by WriterAccess.
LPLE Tracking #1160455-04
Footnotes
1 Defined Benefit Plan
https://www.irs.gov/retirement-plans/defined-benefit-plan
2 Actuarial Valuation Methods
https://www.ecfr.gov/current/title-26/chapter-I/subchapter-A/part-1/subject-group-ECFR686e4ad80b3ad70/section-1.412(c)(2)-1
3 Underfunded single employer defined benefit plans
https://www.irs.gov/retirement-plans/terminations-underfunded-single-employer-defined-benefit-plans