What is a cash balance plan?
A cash balance plan is a type of retirement plan commonly referred to as a hybrid plan since it is a defined benefit plan (i.e., pension) that looks and operates like a defined contribution plan (i.e., 401(k) plan) from an employee’s perspective. Cash balance plans are commonly used by business owners seeking additional tax deductions and accelerated retirement savings. This type of plan is thought to be easier for participants to understand and less volatile for employers to manage than traditional defined benefit plans.
Why a cash balance plan?
Cash balance plans are commonly used by business owners seeking additional tax deductions and accelerated retirement savings. The maximum contribution for a 401(k) and profit sharing plan in 2022 is $61,000. The cash balance plan allows business owners the opportunity to save above and beyond this amount as outlined in the table below. These plans are optimal in a variety of situations, but can be very beneficial for sole proprietor, medical & dental practices, or companies with a few high earners and high employee turnover. Many times, in these scenarios by adding a cash balance plan to an existing 401(k) and profit sharing plan, you can create larger contribution disparity between what is put away for the highly compensated individuals relative to the staff, allowing the highly compensated individuals to create a larger income tax deferral at a relatively low cost.
How does a cash balance plan work?
Each participant in a cash balance plan has an account that accumulates benefits annually from both employer contributions and interest credits. Each year, the employer adds a contribution to the participant’s account based on a formula specified in the plan document. This can be a percentage of pay based on service, age, or points (age + service) or a flat dollar amount.
The account also earns a guaranteed interest credit each year, regardless of the plan’s investment performance. Most plans credit interest at a fixed rate of return between 3% and 5%.
How much can I save into my cash balance plan?
An employer can offer a combination of qualified retirement plans in order to generate the desired owner and employee contributions. Below are the various contribution limits for 2022, determined by the IRS:
| Age | 401(k) | 401(k) with Profit Sharing | Estimated Cash Balance* | Total | Tax Savings (based on 45% tax bracket) |
|---|---|---|---|---|---|
| 30 - 34 | $20,500 | $61,000 | $70,900 | $152,400 | $68,580 |
| 35 - 39 | $20,500 | $61,000 | $90,900 | $172,400 | $77,580 |
| 40 - 44 | $20,500 | $61,000 | $116,400 | $197,900 | $89,055 |
| 45 - 49 | $20,500 | $61,000 | $149,200 | $230,700 | $103,815 |
| 50 - 54 | $27,000 | $67,500 | $191,400 | $285,900 | $128,655 |
| 55 - 59 | $27,000 | $67,500 | $245,500 | $340,000 | $153,000 |
| 60 - 65 | $27,000 | $67,500 | $301,050 | $395,550 | $177,998 |
*Estimated cash balance contributions based on the median for each age range. Maximum 401(k) with Profit Sharing amounts may be lower if compensation is lower than the IRS maximum compensation limit. Other deduction limits may apply.
How do I get my money out of a cash balance plan in retirement?
When participants terminate employment, they are eligible to receive the vested portion of their account balance. Any vested account in a cash balance plan can be paid as a lump sum distribution or annuity. A lump sum distribution can be rolled over to an IRA or another qualified retirement plan.
How risky is a cash balance plan?
The amount of risk in a cash balance plan is determined by the investments within the plan. A wide range of investment vehicles can be used by the plan sponsor to achieve the interest crediting rate. Plan assets are pooled and invested by the trustee. If the plan’s investment earnings exceed the guaranteed rate, the excess will be used to reduce future employer contributions. Conversely, if the plan’s investment earnings are less than the guaranteed rate, then future employer contributions will increase. This will not affect the amount that is credited to each participant’s account. If a catch up is necessary, it is typically spread out over seven years.
What are the differences between a 401(k) and a cash balance plan?
A 401(k) plan is a defined contribution plan, meaning participants contribute funds and choose investments for their individual account within the company plan. A cash balance plan is similar in that each participant has his or her own individual account balance. However, all contributions to the plan are made by the employer. In a cash balance plan, assets are pooled, and investments are chosen by the trustee.
How much would the average person save in taxes using a cash balance plan?
Contributions to a cash balance plan are tax-deductible for the business owner. Tax savings begin the first year the plan is active. The exact amount an employer will save in taxes by contributing to a cash balance plan will depend on their tax bracket. The table above shows several hypothetical examples of potential tax savings for employers with a combined Federal and State tax bracket of 45%.
Similar to other tax-advantaged retirement accounts, the benefits accrued in a cash balance plan are subject to income tax when they are withdrawn during retirement. Part of optimizing the tax benefits of a cash balance plan is evaluating your future tax situation.
For more information
For more information about cash balance plans, please reach out to a Dean advisor. For over 50 years, C.H. Dean has been guiding clients and developing personalized strategies to help clients achieve their financial goals. We are happy to discuss strategies, including cash balance plans, that will enable you to live the life you envision.