With the recent change to federal income taxes on high-paid earners, there is no better time to consider establishing a tax-qualified cash balance plan for your business.
What is a Cash Balance Plan?
A Cash Balance Plan is an IRS tax-qualified retirement plan that looks like a typical savings or profit sharing plan. Each participant has a “hypothetical account” whereby the employer contributes to the account a specified percent of pay or flat amount. The account is credited a rate of return annually (usually based on a government bond yield). Upon termination of employment or retirement, the account balance may be paid to the participant.
A participant’s cash balance account is hypothetical since it is pooled with all other participants’ accounts and is not held in a separate account. The employer makes contributions to the pooled fund and guarantees the specified rate of return. If the pooled funds earn more than promised, future employer contributions may be reduced. If the pooled funds earn less than promised, future employer contributions are increased. Most employers implement a conservative investment strategy to prevent surprise contributions.
What Deduction Opportunities are Available?
Without including a cash balance plan, the maximum single-participant deduction under a 401(k) and profit sharing plan is limited to $56,000 in 2019 ($62,000 if eligible for catch-up contributions). By including a cash balance plan, the maximum deduction opportunity is significantly increased. The chart below shows the potential opportunity based on the owner’s start age.
Who should consider a Cash Balance Plan?
- Companies with relatively stable annual earnings
- Business owners wanting to deduct personal amounts in excess of $56,000
- Professional service groups (e.g. physician groups, dental practices and other professional groups)
- Companies of all sizes (it is generally most efficient when the owners are older than some employees by at least 5 to 10 years)
Why is a Cash Balance Plan better than a traditional defined benefit plan?
- A traditional defined benefit plan generally provides a monthly benefit beginning at age 62 or age 65 based on years of service and final average pay.
- While the same amounts may be accumulated in both a traditional plan and a cash balance plan, the cash balance plan is much easier to understand:
- It is difficult for participants to understand the true value of a traditional plan.
- The value of a cash balance plan is the actual “cash balance”
- Just as the value of a traditional plan is difficult to understand, the calculated liability of a traditional plan varies when interest rates change. When interest rates go down, the liabilities of the plan go up. Due to the current low interest rates, most traditional plans have significant liabilities compared to the assets backing them up. Contribution requirements can vary dramatically from year-to-year based on changes in rates.
- The true liability of a cash balance plan is the sum of all cash balance accounts. Changes in interest rates have very little impact on cash balance accounts. Therefore, contribution requirements are very predictable from year-to-year.
What must be provided to employees?
Since Cash Balance Plans are tax-qualified they are subject to discrimination rules. Contributions to employees will vary depending on the desired owner/key employee deductions. To maximize the owner/key employee deductions, total contributions to employees are generally at least 8% to 10% of employee pay. Actual plan design will vary depending on the age and pay of employees and owners. A sample illustration is provided on the following page.