Pension plans are going extinct in corporate America.
Pensions used to be the retirement plan standard for just about every employer; in 1998, nearly six in 10 Fortune 500 companies offered pensions to new hires. Over time, employers shifted from pensions to 401(k)s with the key benefit of giving employees the power to choose their own investments. In 2015, only 20 percent of Fortune 500 companies offered a pension.
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Today, we see another form of a Defined Benefit Pension: a little-known retirement plan called a Cash Balance plan.
Cash Balance plans have been around for more than three decades, but due to their perceived complexity, not many folks understand the massive benefits.
Most of us understand that wealth-building is based on your ability to save and the return on your investments. But there is a third factor which is often overlooked: minimizing your tax bill!
The Cash Balance plan allows profitable business owners to accelerate savings and pay significantly less in taxes.
Read on to learn:
- The basics of a Cash Balance plan,
- Its benefits and drawbacks,
- Expected costs, and
- Whether a Cash Balance plan will work for your business
What is a Cash Balance plan?
The Cash Balance plan allows owners and partners to reduce their annual tax bite and accelerate retirement savings dramatically.
It is a “hybrid” plan with features of both Defined Benefit and Defined Contribution plans. Each participant has an account that grows annually in two ways:
- An employer contribution, and
- An interest credit, which is guaranteed rather than dependent on the plan’s investment performance.
For the right business, Cash Balance plans can be a great fit, and a good complement to a 401(k). Owners and partners of highly profitable businesses — who may have had a late start on retirement planning — have a chance to catch up through a Cash Balance plan.
Key facts about the Cash Balance plan
How do Cash Balance plans work?
In a Cash Balance plan, a business or professional practice maintains an account for each employee with employer contributions plus interest credits.
How are credits accrued?
Let’s say that your employee Janine earns $75,000 annually at your accounting firm.
She participates in a Cash Balance plan that provides a 5 percent annual salary credit and a 5 percent annual interest credit once there is a balance.
Janine’s first-year pay credit would be $3,750 with no interest credit (as there was no balance in her hypothetical account at the start of her first year of participation).
In her second year, assuming no raises, Janine would get another $3,750 pay credit and an interest credit of $3,750 x 5% = $187.50. So, at the end of two years of participation, her hypothetical account would have a balance of $7,687.50.
Cash Balance plans don’t allow for discrimination in favor of partners, executives, or older employees; the owner(s) must make contributions for other employees. Each year, a plan participant receives a pay credit equaling 5 to 8 percent of their compensation, plus an interest credit. This credit can be variable or fixed, and is usually linked to the performance of an equity index or the yield of the 30-year Treasury.
The plan pays out:
- Lump-sum payouts, or
- A pension-style monthly income stream to the participant at retirement, which can come in the form of a set dollar amount or a percentage of compensation
Finally, Cash Balance plans are generally portable; the vested portion of the account balance can be paid out if your employee leaves before a retirement date.
401(k) Profit Sharing & Cash Balance Plans
*Assuming 45% tax bracket. Taxes are deferred.
Advantages of a Cash Balance plan
Interested in opening a 401(k) plus Cash Balance plan?
This retirement plan combination is complex and requires sophisticated professional advice. We can help.
Considerations to make before opening a Cash Balance plan
Make sure a Cash Balance plan is right for your business needs
A Prosperity Financial Advisor can help you figure out whether a Cash Balance plan will save you money versus another type of retirement plan.
How much does a cash balance plan cost?
Despite the set-up and ongoing maintenance fees, Cash Balance plans offer owners the potential to keep excess profits earned above the annual interest credit owed to employees.
Is a Cash Balance plan right for your practice?
A Cash Balance plan tends to work well for highly compensated employees (HCEs) of a firm who are within their prime earning years.
If you are…
- Age 35+ and wish to accelerate your retirement savings
- An owner or partner of a consistently profitable business with 2 to 10 employees (aim for at least a 5:1 ratio – 1 HCE plan participant for every 5 NHCE participants)
- Interested in making larger contributions than allowed in a SEP-IRA or 401(k)
- Likely to have cash flow to make contributions for 5+ years
- Willing to contribute 3 to 5 percent to employees
… The Cash Balance plan may be the perfect solution for you.
Remember that you don’t need to contribute the maximum amount; you can start saving and gradually build up to avoid surprises that may affect the company’s cash flow. In addition, you have the option to offer a 401(k) to everyone at your company, then add a Cash Balance plan only for partners and administrative staff. You can even adopt dual Profit-Sharing and Cash Balance plans to further accelerate your retirement savings. A Fiduciary Financial Advisor can help you develop a retirement strategy that fits your needs.
Interested in opening a Cash Balance plan?
Your Prosperity Financial Advisor can help you sort out the details to find the right approach for your company.
We Can Help
At Prosperity, we’ll take the time to understand your goals and your business — both where you’ve been, and where you’re headed — and proactively look for ways to improve or spot potential problems.
If you’re a Business Owner or Partner who needs help building the right retirement plan, please fill out the form below. We look forward to speaking with you.