Pensions, IRAs and 401(k)s are familiar concepts to business owners, yet there is another, lesser-known retirement savings strategy that can result in significant tax savings for certain small business owners. A cash balance plan is a defined benefit plan that, similar to a traditional pension, provides a specific benefit at retirement to eligible employees. It can be designed to work in conjunction with an existing defined contribution plan. Unlike defined contribution plans, however, cash balance plans have generous contribution limits that increase with age. This feature makes cash balance plans attractive to older business owners seeking to turbocharge their retirement savings beyond the annual tax law limitations associated with defined contribution plans.
Use of cash balance plans is on the rise, as more small business owners discover the advantages of adding this plan onto their existing 401(k) plans.
Ideal candidate for cash balance plans
If you answer yes to the majority of these questions, your small business may benefit from establishing a cash balance plan for its employees:
- Do you or your business partners want to increase your retirement savings rate significantly?
- Does your existing defined contribution plan limit the amount you want to save?
- Does your business produce steady income?
- Do you or your business partners have annual income greater than $250,000 and seeking an annual tax deduction greater than $57,000 (2020)?
- Does your company have fewer than 15 employees per one owner?
- Are you and your business partners generally older than your employees?
- Are you already funding a five percent or more contribution of employee compensation? If not, are you interested in doing so?
Ninety-two percent of cash balance plans are used by organizations with fewer than 100 employees, and 57 percent of these have 10 or fewer employees.
How do cash balance plans work?
The plan is held in a pooled investment account managed by an investment manager. A participant’s account is credited each year with a “pay credit” (percent of compensation) and an “interest credit” (either a fixed rate or variable rate linked to an index). Increases and decreases in the value of the plan’s investments do not directly affect the benefit amounts promised to participants. The investment risk is borne by the employer. A cash balance plan must be implemented as a permanent option, but it can be terminated for a legitimate business reason.
Sample 401(k) and Cash Balance Combination
(for Professional Service Organization)
Maximum Compensation: $285,000 (2020)
Total Plan Compensation: $989,047
Maximum DC Deductible Limit: $59,343 ($989,047 x 6%)
How do cash balance plans differ from other retirement savings options?
Traditional pensions (or defined benefit) plans define an employee’s benefit as a series of monthly payments for life beginning at retirement. Cash balance plans define the benefit in terms of an account balance.
Another difference is how amounts are credited. In defined contribution plans, amounts credited to accounts depend on the actual investment performance of plan assets. In a cash balance plan account, interest is credited on an annual basis, based on a specified rate or index. A fixed rate of five percent is common in cash balance plans.
In a 401(k) or other defined contribution plan, the monthly benefit hinges upon the amount of contributions as well as the investment gains or losses on the account.
Cash balance plan benefits include:
- Pay less in taxes and save more for retirement
- Powerful tax deferral strategy to maximize benefit for owner(s)
- Contribute $200,000+ tax deductible and tax deferred (if over age 60)
Key considerations for cash balance plans:
- Value fluctuation (investment risk borne solely by employer)
- Inflexible funding (regimented contribution amount prevents discretionary saving)
- Administrative expense and complexity
What parties are involved in a cash balance plan?
The employer serves as cash balance plan fiduciary, responsible for selecting and monitoring service providers and funding the plan.
The employer’s investment advisor selects, monitors and modifies investment options in the pooled account. This advisor also facilitates communication between the employer and the actuary/trustee.
Cash balance plans require the services of an actuary to create plan documents, conduct annual actuarial calculations and compliance testing and prepare participant statements and Form 5500.
RKL Wealth Management has a team of retirement plan experts who assist businesses with maximizing their savings and tax benefits. Ready to learn more or get started? Contact your RKL advisor or RKL Wealth Management advisor or reach out to us via the below form.