Cash Balance Plans for High-Earning Owners & Partners 

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:

  1. An employer contribution, and 
  2. 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

  • Offers much higher annual contribution limits than a 401(k). You can contribute up to $58,000, or $64,500 if you’re 50 and older. 
  • Provides a guaranteed retirement benefit. Contributions also grow tax-deferred at a set interest rate, typically 4 to 5 percent, rather than based on investment performance
  • Annual contributions are age-weighted. Older owners can double or triple their pre-tax contributions. 
  • Not for every business. Cash Balance plans require consistent contributions, and will work best for owners and partners with consistent profitability and discretionary income. Yet, they may cost less than a classic pension plan while offering significantly more funding flexibility and employee benefits compared to a defined contribution plan, such as a 401(k).

  • 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

    Contribute and deduct more.

    The limits for a Cash Balance plan are always higher than those for a 401(k), and contribution limits only increase with age. Compare the maximum contributions for 2021:

    *Assuming 45% tax bracket. Taxes are deferred.

    Since employers make contributions on behalf of participants, all contributions are tax-deductible. For owners, those tax savings can flow through to their individual tax returns. And just like a Traditional 401(k) or IRA, your retirement savings grow tax-deferred. 

    Use in tandem with 401(k) plans.

    And you can contribute the maximum to both. That means, at 55 years old, you could save up to $293,500 annually!

    It also will provide the largest aggregate contributions for owners while preserving the greatest amount of flexibility related to the company cost for all other participants.

    Ideally, these plans should be aggregated for discrimination testing purposes (rather than being tested as two isolated and separate plans). 

    Reward owners appropriately.

    As compared to a Traditional 401(k) using a Safe Harbor formula, rank-and-file employees may be rewarded more than owners and executives would prefer.

    Benefit allocations are based on career average pay.

    With a Traditional Defined Benefit plan, the monthly pension or lump sum is determined by the “best years” — a 3- to 5-year average of peak employee compensation multiplied by years of service. In contrast, in a Cash Balance plan, the benefit is determined using an average of all years of compensation.

    Protect your account balance.

    Unlike other retirement plans where a participant’s account balance can potentially decline depending on investment performance, your savings in a Cash Balance plan don’t fluctuate. 

    Instead, there’s a set an interest crediting rate—typically 4% or 5% annually—and participants receive contributions plus that growth when they retire. This is achieved when your Cash Balance plan assets are pooled and managed by your Financial Advisor, so participants don’t need to pick their own funds and manage their asset allocation.

    Cash Balance plan participants have a degree of protection for their balances. Their benefits are insured up to their maximum value by the Pension Benefit Guaranty Corporation (PBGC), a U.S.  federally chartered corporation created by the Employee Retirement Income Security Act of 1974 (ERISA). If a plan is terminated, participants can receive their balances as a lump sum.

    Shield your retirement from interest rates.

    As rates rise and fall, liabilities in a Traditional Pension plan fluctuate. This opens a door to either overfunding or underfunding. (Underfunding is a major risk during times of low interest rates). 

    By contrast, Cash Balance plans are less sensitive to interest rates and have relatively minor variations in liability valuation.

    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

    Prepare for record-keeping costs.

    Because employers must keep records of individual plan accounts, record-keeping costs for a Cash Balance plan may be higher than under a Traditional Pension plan. The plan must cover at least 50 employees or 40 percent of the firm’s workforce.

    In addition, an actuary must certify each year that the plan is properly funded. 

    Confirm cost efficiency beforehand.

    While a Traditional Pension plan generally allows you to defer payment of benefits until employees retire, a Cash Balance plan generally allows terminating employees to take their vested benefits with them (i.e., cash out or roll over the benefits). 

    When benefits remain in a Traditional Pension plan until employees retire, you are generally able to keep the earnings on that money. That’s why a Cash Balance isn’t always more cost-efficient than a Traditional Pension plan. 

    Work with qualified TPAs to maintain the plan.

    A Cash Balance plan requires some upkeep:

    • It must pass yearly non-discrimination tests
    • It must be submitted for IRS approval every five years (instead of every six)
    • A Plan Document must be drawn up and updated regularly
    • Employers must comply with annual reporting and disclosure requirements

    Employers must commit to annual contributions.

    Unlike a 401(k) plan where employees generally make the bulk or all of the contributions, employers who establish or convert to a Cash Balance plan must commit to making all of the plan contributions. An actuary must determine the minimum yearly contribution to keep the plan appropriately funded.  

    Employers assume the investment risk.

    If your Cash Balance plan promises participants a fixed 5 percent interest credit each year, you, the employer, may have to contribute more to the plan whether or not you have profits or the cash to do so.

    Abide by contribution rules and deadlines.

    Employer contributions to the plan for a given tax year must be made by the federal income tax deadline for that year (plus extensions). You can fund the plan before the end of a calendar year, but any overages are not tax-deductible.

    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.

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    Advisory Services offered through Prosperity Financial Group, Inc., an independent registered investment advisor. Securities offered through Fortune Financial Services, Inc. Member FINRA/SIPC. Prosperity Financial Group, Inc. and Fortune Financial Services, Inc. are separate entities.

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