I’m going to be honest with you. Cash balance plans can be intimidating. But they don’t have to be. You just have to understand a few key requirements.
Many business owners just want to maximize contributions so that they can get big tax benefits. But there are certain rules in how pay credits and interest credits can impact the contribution.
In this post, we will take a look at the cash balance plan pay credit formula. Let’s dive in.Smart Links
- What is the pay formula used in a cash balance plan?
- How do the pay credits work?
- How is a cash balance plan calculated?
- How does the cash balance plan formula work?
- What about the interest rate?
- Bottom line
What is the pay formula used in a cash balance plan?
A cash balance plan is a type of defined benefit plan. It appears to look a little like a money purchase plan, but that’s a topic for another day.
First, a hypothetical cash balance account is set up for each participating employee. Typically, the account balance begins at zero in year one. From that point forward, interest credits and pay credits are added to the beginning of year hypothetical account balance.
Pay credits are generally expressed as a specified flat percentage of pay or a flat dollar amount. This “credit” is then added to the account each year. But it’s careful to note that the sum of these credits will typically not be the same as the contribution made by the employer to fund the plan.
In addition to pay credits are interest credits which are added to the cash balance account. The rate of interest credited can vary on an annual basis, but the method for determining and allocating it must be specified upfront in the plan document. It is not allowed to be made at the sole discretion of the company.
The interest rate allocated can be either a fixed rate or tied to an index, such as a Treasury note rate or the consumer price index. The interest rate is allowed to be tied to the actual plan investment return in some cases. Although that can create very volatile results when it comes to testing the plan and lead to volatile annual contribution requirements.Looking for more information on cash balance plans? Take a look at our ultimate guide to cash balance plans. Discover our favorite strategies!
How do the pay credits work?
A wide range of pay credit rates are available. Most plans use a percentage of pay, but a flat dollar amount is allowable. The choice is made by the company before the plan is adopted. It should be analyzed for cost, ease of administration and to ensure that it fulfills the employer’s objectives.
For the benefits to be definitely determinable, the plan document must specify the pay credits. If the plan sponsor ever wants to change the pay credit, it is allowed provided that the anti-cutback rules with regard to the accrued benefit are satisfied.
Examples of pay credits include:
- $5,000 for each participant
- 5% of compensation for each participant
- $1,000 per year of service
- 4% of compensation for each participant with fewer than 65 points, and 5% of compensation for each participant with at least 65 points. Total points are equal to the sum of age and years of service.
Note that in the last bullet above, a newly hired 45-year-old participant has 45 points. The same person after 10 years of service will be age 55 with 10 years of service resulting in 65 points. Care must be taken, however, so that pay credits that increase with service do not violate the accrual rules against back loading under IRC 411(b).
Generally, the pay credit is applied to the current year compensation at the end of the year. Eligible current year compensation will be defined in the plan, and could either include or exclude bonus and overtime, just as in a final average compensation defined benefit plan.
Integration with social security is an allowable option when selecting a pay credit structure, whereby benefits are skewed to the higher paid, similar to a traditional defined benefit plan. An example of this is a 6% pay credit for compensation above the Social Security Taxable Wage Base, plus a 4% pay credit for compensation below the wage base. There is no safe harbor permitted disparity formula available for cash balance plans, therefore general testing is commonplace.
How is a cash balance plan calculated?
So let’s take a look at an example of how the pay credit formula would work. It’s sounds very complicated but it is not. You don’t have to be a CPA to perform the calculation (although it helps). Here is the 5 step process:
- Beginning of year account balance is $20,000
- Interest crediting rate is 5%
- Compensation (typically the W2) is $100,000
- Pay credit is set at 4% of pay
- End of year account balance is ($20,000 × 1.05) + ($100,000 × 4%) = $25,000
The hypothetical cash balance accounts are just a bookkeeping measure used to keep track of each participant’s accrued benefits. They do not directly tie to the actual plan assets.
A cash balance plan is considered a type of defined benefit plan because the accrued benefits are not solely determined by the value of assets in a specific allocated account. As a defined benefit plan, the company contributions will be calculated using actuarial assumptions. The underlying asset value will generally differ from the sum of all the participant accounts.
How does the cash balance plan formula work?
Should the cash balance plan be a converted from an existing defined benefit plan, the participant’s account balance would be the sum of the former accrued benefit plus any earned benefit from “post” conversion service that uses the cash balance plan formula. Conversions must also preserve any accrued benefit with the future service creating cash balance account additions using pay credits and interest credits.
Cash balance plans require companies to optimize investments for the benefit of the plan participants. The investment strategies and goals should be carefully analyzed (at a minimum on an annual basis) to determine any shortfalls. Companies should avoid unanticipated contributions or shortfalls by doing thorough research on asset allocation, pay credits, and interest crediting rate.
A new cash balance plan (one that is not a converted) can fortunately grant past service credit that would be in the form of an opening cash balance account. This can be a tremendous benefit in the first year of set up.
What about the interest rate?
Plans do have a stated interest rate credit. In reality, the plan sponsor can invest the assets as they see fit. As long as there is not too much volatility in the investment returns, there will not be that much of an impact on annual contribution amounts.
But be careful with big swings. If the plan invests in speculative stocks and suffers a big decline, you will generally see larger contributions in future years. On the contrary, if there are large investment returns the result may be lower future contributions.
How to calculate a cash balance plan contribution:
- Start with the beginning account balance
Your starting account balance is critical because your interest crediting rate is applied against this amount. Your final valuation reports from the prior year will contain all account information.
- Determine the interest crediting rate
Most interest crediting rates are 5%. This rate is standard because it is most representative of market returns and also will help pass testing when additional employees are involved. Multiply the beginning balance times this amount with a 1 in front. For example, 1.05.
- Obtain the W2 compensation
Assuming the company is a C-Corp or an S-Corp, you need to obtain the W3 (a summary of the W2s). This will have all employee compensation and becomes a basis for the pay credit calculation.
- Determine the annual pay credit
This is specified in the plan document and will usually be a set percentage of pay. In most cases this will be a nominal amount like 4%.
- Calculate the final amount
The ending balance is calculated as follow: (Beginning balance × 1.05) + (W2 compensation × 4%). This assumes that all employees are eligible and included in the calculation.
So there you have it. The cash balance plan formula is spelled out in plain english. Don’t be intimidated. Setting up a plan may be a great business and retirement decision for you.
Just make sure that you discuss and review with your CPA and TPA so that you can adequately plan your contribution. As always, if there are any questions that you may have, we’re here to help.