Employer-Sponsored Cash Balance Retirement Plans: A Tax-Saving Strategy
A cash balance plan is a retirement vehicle with features similar to a 401(k). It’s a form of a defined benefit (DB) pension plan that is funded entirely by the employer (i.e., the plan sponsor). Organizations use cash balance plans to complement 401(k), profit sharing, Simplified Employee Pension (SEP), or other defined contribution (DC) plans because they allow business owners and highly paid partners, professionals, and leaders to put away more money and save tax dollars.
Although cash balance plans have been around for more than 20 years, they didn’t gain popularity until recently. Tax hikes on high-income earners in The American Taxpayer Relief Act of 2012 (ATRA) have resulted in a deluge of plan adoptions because these types of plans can be a powerful tax-saving tool for plan sponsors and participants. ATRA wasn’t kind to people who accumulate income. Our article “Fiscal Cliff Legislation: Extenders, Increases, Modifications, and Strategies,” provides details on the tax increases for upper income individuals, trusts, and estates, which began in 2013.
The added value of cash balance plans
Consider a cash balance plan if you’re looking to help reduce taxable income for your business while significantly increasing pre-tax retirement contributions for yourself and other high income employees.
Benefits for your organization
- Possible opportunity for increased tax deductions
- Ability to weight benefits toward key employees
- Incentive for recruiting and retaining the best talent
- More predictable costs than traditional DB plans
Benefits for your employees
- Fully funded by the plan sponsor
- Potential to quickly accumulate tax-deferred wealth
- Hypothetical account balances, making retirement contribution options easy to understand
- The benefit is portable in the event of a job change or termination
Types of organizations and employees best suited for cash balance plans
Cash balance plans generally work well for:
- Privately held and family businesses and their owners
- Professionals, including executives, partners, physicians, attorneys, and others who are typically:
- Considered seasoned (at least 45 years old)
- Consistently earning significant income
- Paying a large amount in taxes (usually $100,000 or more)
- Seeking an enhanced benefits package
- Looking for a way to accelerate retirement savings
- Currently maximizing 401(k) and profit sharing contributions
- Willing to commit to annual contributions for a 5- to 10-year period
Frequently asked questions
How do benefits work in a cash balance plan?
The plan sponsor makes contributions for each eligible participant based on a formula that takes into account the person’s age, years of service, and compensation. At retirement age, participants who have met the plan’s vesting requirements qualify to receive benefits, which usually come in the form of scheduled monthly payments.
Benefits in cash balance DB plans are defined as a hypothetical account balance (HAB). The plan promises to pay the HAB regardless of the actual investment returns, which is the biggest difference between cash balance plans and 401(k), profit sharing, or DC plans. An HAB is made up of two components: cash credits and interest credits.
Similar to profit sharing contributions, cash credits are annual amounts that get credited to an HAB. They are a percentage of pay, a flat dollar amount, or a percentage of the maximum permitted by law. Cash credits vary by participant and are added to the HAB as of the last day of the plan year.
Based on the plan’s provisions, interest credits apply to the HAB annually, but must not exceed a market rate of return. Interest credits are either a fixed or variable rate that connects to an index, such as a 30-year U.S. Treasury bill rate from the preceding year, or at a conservative fixed rate of no more than 5 percent.
An employee is participating in a cash balance plan that provides an annual cash credit of $150,000 and annual interest credits of 5 percent.
|Interest Credit||Cash Credit||HAB at
How does performance affect benefits?
Performance doesn’t affect the benefits. Regardless of the actual asset returns, cash balance plans pay the HAB. The plan sponsor is responsible for contributing additional amounts to fund shortfalls if assets underperform. However, if the assets outperform the interest credits, the plan sponsor can contribute a lower amount. To mitigate the effects of a volatile market, plan assets are usually invested in stable funds that stay close to the interest crediting rate in the DB plan.
Do cash credits vary by participant?
Yes. Cash balance plans can be designed to take individual goals into account. Therefore, these plans are ideal for offering employees tailored cash credits; however, this topic should be thoughtfully considered and discussed during the design phase of the plan because cash balance plans are meant to be long-term retirement vehicles that don’t change often.
How are benefits paid?
Benefits can be paid to qualified participants in one of several annuity options, usually in the form of scheduled monthly payments. However, with spousal consent, participants can also receive their HAB in a lump sum amount as long as the cash balance plan is adequately funded.
How are maximum contributions determined?
Maximum annual cash credits are based on age.
The table below shows the estimated maximums for several ages assuming the participant’s compensation exceeds $255,000.
Can a participant take a distribution prior to retirement?
Yes, but there’s usually a 10 percent penalty for distributions prior to age 59 ½ if the plan terminates and the assets aren’t rolled into an individual retirement account (IRA). A participant can get money out if the plan provisions allow and she/he is still working after age 62 and meets certain funding criteria.
Can plan sponsors contribute different amounts during different years depending on their profitability?
Although DB plans will have a flexible range of contribution options during the design phase, they have annual funding requirements. Therefore, plan sponsors should only set up contribution levels they’re comfortable making each year regardless of unexpected profits. As mentioned before, cash balance plans are meant to be long-term retirement vehicles and shouldn’t change often.
In addition, the IRS requires DB plans to be set up with the intent of being permanent. If the IRS determines a plan has been set up temporarily, the agency may disqualify it for that term of operation and disallow tax deductions. A plan usually has to exist for 5 to 10 years for the IRS to consider it permanent.
Who is the plan trustee?
The owner or owners of the business are usually the plan trustee(s).
Who handles the management of the investments?
Employers control the investment options of cash balance plans and bear the investment risk. The investments are either managed by the employer or an investment manager appointed by the employer.
What administrative requirements are associated with a cash balance plan?
- As mentioned in the previous section, employers control the investment options and bear the investment risk.
- Participation requirements depend on the design of the plan, which take non-discrimination rules into consideration.
- Plans must be funded at least annually.
- Typically, plans must pay insurance premiums through the Pension Benefit Guaranty Corporation (PBGC).
- An IRS Form 5500, the annual return/report of employee benefit plans, must be filed, and other reporting requirements may apply.
How we can help
We serve as objective advisors to your plan’s trustees. CliftonLarsonAllen helps clients design cash balance plans around your organization’s goals and the goals of your key people — because your key people make your business what it is. We only need a minimal amount of information to provide you with a variety of plan options.
When the design phase is complete, we can help you implement the plan, and manage the investments. We can also coordinate our work and provide assistance with the administration and investment management of your 401(k) plan.
Investment advisory services are offered through CliftonLarsonAllen Wealth Advisors, LLC, an SEC-registered investment advisor.