By now you probably understand the advantages of a cash balance pension plan. These are easy. But how much do you know about the disadvantages? These are a little more challenging.
Cash balance plans are often misunderstood. When I discuss them with clients I try to make it very clear what the downsides are.
In this post, I will explain some of the critical issues. This will help you determine if a plan is right for your situation.
- A simple table
- A closer look at the advantages
- A closer look at the disadvantages
- How to weigh your decision
- Consider your pension options
A simple table
I will try to make this easy. The table below offers a quick reference guide (click on the smart link in the table to be taken directly to the section).
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A closer look at the advantages
Many people see the advantages of cash balance plans and dive in. But don’t be too quick. You should carefully analyze the plans and make sure you are educated. Let’s take a look at the advantages and give you a detailed review.
This advantage is clear cut. A cash balance plan allows you to contribute a much higher amount than other retirement vehicles.
The plans don’t really have annual contribution limits like 401(k) plans. The goal is to have a large specified amount at retirement (usually age 62). As such, annual contributions can be as in excess of $300,000, subject to age and income.
Bottom line: if you want get $100,000 annually into retirement then this is usually your best option. A 401(k) plan will not even come close.
Funding Flexibility: Remember you have a range
Many people think that plan contributions are fixed. While these plans can be structured as fixed contributions, most plans allow for more flexible funding.
In reality, you are given a range. The range will represent minimum and maximum funding amounts. Typically, there is a targeted funding amount that is usually somewhere in the middle.
This range gives you some flexibility to make larger contributions in a year with high profits and lower contributions in down years.
So in reality, you have more funding flexibility that you might think. In addition, with each year of service the range tends to widen. This can make it very easy to get the contribution you desire while staying in compliance.
Combining Plans: Nice way to turbo charge
Not only are you able to contribute more to a cash balance plan, you can also combine them with 401(k) plans. When you combine the plans together you can turbo charge your contribution. But there is one limitation.
401(k) plans (with profit sharing contributions) will limit any profit sharing to 25% of compensation. This does not impact the employee deferral.
But when a 401(k) plan is combined with a cash balance plan, the company is restricted to a 6% profit sharing contribution. Usually this is not much of a problem because the cash balance contribution is so large it makes up for the smaller profit sharing amount.
In fact, combining plans is so popular I would guess that 90% of the plans we do are combos. They just allow you to get larger contributions for minimal additional cost.
Tax Deductible: The #1 tax strategy
Did I mention that the contributions are tax deductible? These plans are “qualified” plans just like 401(k)s. What this means is the contributions going into the plan are tax deductible and then are taxed once withdrawn.Looking for more information on cash balance plans? Take a look at our ultimate guide to cash balance plans. Discover our favorite strategies!
However, the funds can be rolled over into a 401(k) plan or into an IRA to avoid taxation. This is the most selected option.
Make sure you discuss your marginal tax bracket with your CPA. The higher the rate the more these plans make sense. There is a reason why many of our new plans come from states like California and New York.
Age-Weighted Contributions: The older the better
The contributions under these plans is age-weighted. This is a huge benefit for most business owners, but will make them more challenging for younger folks.
The older we get the more money we make and the more focused on retirement planning we get. This makes sense. When we are younger we see ourselves living forever and we usually don’t have much money to contribute to retirement anyway.
Considering a Cash Balance or Defined Benefit Plan?
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Our average client is probably around 50 years old with income of $400,000 plus. At this age, retirement planning is almost as important as tax deferral strategies.
Most plans are set up with a retirement age of 62. Since the plans are aiming for a retirement balance at age 62, the older we get the closer to that age we become. This is why contributions are much higher for 60 year olds compared to 30 years olds.
A closer look at the disadvantages
So by now you understand all the pros and why these can be great tax and retirement structures. But what about the downside? Is there a catch?
Well yes…sort of. There are some cons that you need to be aware of. Bottom line: they are best suited for business owners with consistently high income who are 40 years of age plus.
Conservative Investments: Not as bad as you might have thought
Many people believe that cash balance plans should be invested in conservative assets. They think that they are supposed to sacrifice nice returns for a safe retirement plan.
Well this isn’t actually correct. It is true that plans have a stated interest rate credit, which is normally around 5%. So in theory the plan should aim for investment returns that will mimic this stated crediting rate.
All things being equal, higher returns can lead to lower future funding and lower returns will result in high future funding. So the real goal is to limit volatility.
I tell clients who want to make more risky and speculative investments to do it in their 401(k) plans. It’s because 401(k)s establish a funding amount upfront. Once the money goes into the plan, the investment returns do not impact the plan.
Higher Pension Plan Cost: Make sure to check around
401(k) plans are relatively inexpensive. They can be free from some providers and custodians, or can run a few hundred dollars when there is a 5500 filing required.
There is no doubt that these plans are more expensive than 401(k) plans. But when you compare the cost to the benefits, I certainly believe these plans can be a bargain for the right business.
We set up these plans for solo business owners for only $990. Annual administration will cost you around $2,000. So the higher cost is evident.
But with the average plan contribution around $150,000 and marginal tax rates of approximately 40%, it doesn’t take much for the plan costs to be justified.
But don’t set these plans up if you only want to do make a contribution of $20,000 or $30,000. Stick with a 401(k) plan. That is of course unless your tax bracket is so high that you want to ring out all the tax savings you can.
Permanency: A problem for some
Yes permanency can be an issue. But does permanent mean forever?
Well the IRS says that permanent is not forever. They say the plan should be open for at least a “few years.”
There is no doubt that these plans should not be start and stop. You should plan on having them as an ongoing part of your business. But if you have the plan open for a few years and then terminate it, you should not have a problem with the IRS as long as you acted in good faith.
There is no doubt that you will see many plans being terminated as a result of Covid. But remember that you don’t have to shut down your plan just because your income is down. You can amend the plan to lower the interest crediting rate or change the formula. You have options.
One of the biggest advantages of 401(k) plans is that they are elective. If you have a down year you opt to not contribute. You can max fund in a good year. The point is that the contributions are elective and are not mandatory.
But cash balance plan contributions are not as simple. Unless a plan is overfunded, you will have to make a contribution annually.
Even though you have a funding range, you must at least make the minimum contribution or you will be faced with an excise tax.
These mandatory contributions scare a lot of business owners. But in reality, they usually aren’t that bad. Many businesses have funds in their bank account that was earned in prior years.
In addition, remember that you have up to the date you file your tax return (including tax extensions) in order to make the contribution. So even though your profits may be down slightly now, you may have the cash to make your contribution next year. Minimum funding is usually not a deal breaker.
More Complexity: This is a given
You don’t get something for nothing. The large tax deductible contributions come at a cost – an emotional cost. These plans give some folks headaches.
These plans are complex and require careful coordination with your third-party administrator, CPA and financial advisor. In fact, many advisors and accountants don’t understand the plans. This makes your situation even more daunting.
Considering a Cash Balance or Defined Benefit Plan?
See if a plan is right for you and your business
So you need to accept that your financial situation has created some additional work for you. But if you can get through the first year, you should be fine.
How to weigh your decision
- Determine the other, if any, types of retirement structures you’ll need. Cash balance pension plans can be used alongside other retirement plans, such as a 401(k).
- Take a look at the costs of opening up a Cash Balance Plan versus traditional options. Cash balance plans typically have higher costs associated with set up and maintenance.
- Analyze how much you can reliably contribute to a pension retirement plan. The biggest benefits of Cash Balance Plans include high contribution limits, as well as “catch-up” contribution options, which may or may not favor your situation.
- Make sure you discuss with your financial advisor. A financial advisor knows the most about your situation and can confidently point you towards the most beneficial plan.
- Fund the plan timely. The IRS sets guidelines for timely contributing to your plan. Make sure to get the payment made before you file your tax return.
There are many advantages, so let’s highlight a few of them:
1) Large contributions. Funding is substantially higher compared to 401k plans and SEPs.
2) Funding flexibility. You are given a funding range that allows for minimum and maximum contribution levels.
3) Age-weighted contributions. Contributions will increase with age, which allows owners who are close to retirement higher funding.
4) Ability to combine with other plans. These plans can be easily combined with other retirement plans (like 401ks) that allow for maximum benefit.
5) Tax deductible. Because these are qualified plans, all contributions are tax deductible.
As with any qualified plans, there are downsides. Let’s list out some of them.
1) Permanency. These plans are not elective and, as a general rule, annual contributions are required.
2) Plan fees. Each plan requires actuary sign off. This greatly increases the cost.
3) Conservative investments. The plans come with an interest credit of usually 5%. You should try to minimize volatility and match this rate if possible.
4) Increased complexity. These plans can be challenging to understand.
For most people, the decision comes down to answers to the following:
1) What are your federal and state tax brackets? If someone is in a 44% tax bracket these plans will have big savings compared to someone in a 25% tax bracket.
2) What are your desired contributions? If you want to contribute $150k each year these plans are really your only option. You just can’t get contributions that large with a 401k or SEP plan.
3) Can you commit to a plan for a few years? Remember that these plans are permanent, but you are able to close them with reasonable cause.
First, discuss your situation with your CPA or tax preparer. Once you are ready, find a qualified third party administrator (TPA) who can set up the plan for you. Once the plan is established, you will need to decide on a custodian who will maintain your brokerage account. Then just write the check!
Consider Your Pension Options
When it comes to retirement accounts, the goal is to incentivize people to save for retirement, while at the same time restricting them from taking advantage of certain loopholes.
Hopefully, you have had a chance to weight the cash balance plan advantages and disadvantages so you can make the best decision.
7 Citations from Pension Research Articles
- The U.S. Department of Treasury statement of position. Retrieved from https://www.treasury.gov/press-center/press-releases/Pages/js172.aspx
- IRS Determination of cash balance plan issues. Retrieved from https://www.irs.gov/retirement-plans/determinations-cash-balance-plan-design-issues
- Investment News: Pension conversion issues. Retrieved from https://www.investmentnews.com/pension-conversion-the-issueirs-all-ears-on-cash-balance-plans-2152
- Journal of Accountancy: Assessing the business and accounting implications. Retrieved from https://www.journalofaccountancy.com/issues/2000/feb/cashbalanceconversions.html
- BLS: The new wave of cash balance plans. Retrieved from https://www.bls.gov/opub/mlr/cwc/cash-balance-pension-plans-the-new-wave.pdf
- Groom: The IRS reopens determination letter period. Retrieved from https://www.groom.com/resources/irs-reopens-determination-letter-program-for-two-significant-groups-of-plans/
- PWC: Equity Planner for cash balance plans. Retrieved from https://www.equityplanner.pwc.com/HRS/EquityPlanner/EPv1.nsf/969542fe19fc5ea58525752800832ebc/39b3604bdb6319af852577c4007511cb?OpenDocument