What Is a Cash Balance Plan?
In a cash balance plan, the employer commits to providing participating employees with two annual credits:
- Contribution Credit: A fixed percentage of salary or a flat dollar amount.
- Interest Credit: A guaranteed return, often around 5%, regardless of actual investment performance.
These credits are tracked in a “hypothetical account” for each participant, representing their promised retirement benefit. While the account resembles those in defined contribution plans like 401(k)s, the employer guarantees the interest credit, classifying it as a defined benefit plan.
Why Consider a Cash Balance Plan?
Cash balance plans offer compelling benefits for business owners, including:
- Accelerated Retirement Savings: Older owners can make significant “catch-up” contributions.
- Higher Tax Deductions: Contributions often exceed the limits of defined contribution plans.
- Customizable Plan Design: Plans can prioritize owners and key employees.
- Enhanced Employee Retention: Attractive benefits help retain top talent.
While these plans provide a powerful tool for retirement and tax planning, several factors should be carefully evaluated before setting one up.
Key Features and Considerations
1. Mandatory Contributions
Unlike discretionary contributions in 401(k)s, cash balance plan contributions are required and must follow the formula set in the plan document. Plans are typically designed to remain active for three to five years.
2. Defined Contribution Formula
Contribution credits are based on age, compensation, and a pre-determined formula. Any changes to this formula require amending the plan, which cannot occur annually.
3. Pairing with Defined Contribution Plans
Cash balance plans often work alongside defined contribution plans, such as 401(k)s. To pass nondiscrimination testing, employer contributions to both plans may become mandatory.
4. Impact of Demographics
Changes in your workforce can significantly influence the cost of maintaining the plan, particularly if the employee count or compensation levels shift.
5. Pooled Investments
Plan assets are managed in a pooled account by the plan trustee. Unlike 401(k)s, individual participants do not direct their investments.
6. Guaranteed Interest Credits
The plan guarantees an annual interest credit, ensuring predictable growth. Investment returns above the guaranteed rate reduce future required contributions, while underperformance increases them.
7. Surplus Management
If plan assets exceed participants’ hypothetical account balances, a surplus is created. Surpluses offer flexibility in funding future contributions but may incur a 50% excise tax if not handled correctly during plan termination.
8. Amendments and Compliance
The plan can be amended to adjust future contribution credits. However, benefits earned within a plan year cannot be reduced retroactively. Failing to meet minimum funding requirements triggers a 10% excise tax.
9. PBGC Premiums
Cash balance plans are subject to annual Pension Benefit Guaranty Corporation (PBGC) premiums—$96 per participant in 2023. Some exceptions apply to plans for substantial owners or small professional groups.
10. ERISA Bond Requirements
Plans covering non-owner employees require an ERISA fidelity bond equal to 10% of plan assets to protect against potential fraud.
11. Tax and Regulatory Compliance
Excess contributions beyond the tax-deductible limit incur a 10% excise tax. Contributions can only begin after signing the plan document. Additionally, the IRS mandates restating plan documents every six years.
Final Thoughts
Cash balance plans are a powerful tool for building retirement wealth, minimizing tax liabilities, and rewarding employees. While the benefits are significant, these plans come with responsibilities that require diligent oversight and strategic planning. Follow AccelUS for more!