I get it. Understanding how cash balance plans work can be challenging. Some may even give up.
But what if you had a strategy that allowed you to get $3 million into retirement? It might make sense to understand the details.
These plans can be difficult to understand, but for the right business owner they can be a home run. That’s why we call them the best retirement strategy in 2021. So let’s try to get through the basics and explain a few key details.Smart Navigation
- What is a cash balance plan?
- What is the difference between a 401k and a cash balance plan?
- Can you have a cash balance plan and a 401k?
- Cash balance plan vs 401k
- The Case for the Cash Balance Plan
- The Case for the 401K
- How to determine which plan is right for you
- Bottom line
What is a cash balance plan?
So let’s start at the beginning. Retirement plans can be broken down into two classes – defined contribution plans and defined benefit plans.
Defined benefit plans essentially look to fund a specified benefit amount at retirement. But defined contribution plans are a little different. These plans specify a maximum funding contribution up front without regard to a future balance. Cash balance plans are a type of defined benefit plan, while 401k plans are an example of a defined contribution plan.
A cash balance plan allows large annual contributions, with an ultimate goal of $3 million. The benefit is based on a formula defined in the plan document. This document also contains provisions regarding retirement age and other plan assumptions.
Get a FREE 30 Minute Consultation!
Paul Sundin, CPA has written on retirement plans for Inc. and Kiplinger. He focuses on cash balance plans and defined benefit plans. Schedule a FREE 30 minute call with him:
The plan actuary reviews the funding on an annual basis. The actuary will use assumptions such that they will reasonably fund the benefit at retirement age. In other words, the actuary needs to determine an annual contribution to the plan.
Tell me about the mechanics
Based upon the assumptions and method chosen, there is a minimum funding requirement each year. The traditional qualified defined benefit plan provides a stated monthly benefit at retirement for as long as the participant lives. Also, defined benefit plans must, by law, provide benefits to a participant’s spouse and may provide benefits to other beneficiaries as well.
In a defined benefit plan, the employer guarantees the benefit that the participant is to receive. The employer bears the investment risk. The company has to make sure that sufficient contributions are made to pay the retirement benefit. Accordingly, the company must generally increase contributions to make up for any unexpected investment losses.
Besides the cash balance plan, other examples of traditional defined benefit plans are flat benefit, unit benefit, floor-offset, cash balance and fully insured IRC §412(e)(3) plans. Defined benefit plans can provide benefits other than retirement benefits (for example death or disability benefits) based on objective criteria.
What is the difference between a 401k and a cash balance plan?
A 401(k) plan is one of the more common retirement vehicles. A cash balance plan is not so common. The cash balance plan is a type of pension plan that has some similarities a 401k plan. But those similarities can be very subtle.
Many have confused a cash balance plan with a 401(k) plan. But they are very different. In this post, we look at the difference between a 401k plan and a cash balance plan. What’s the best plan? Well it depends.
So let’s start off with the basics. A 401k plan is a type of defined contribution plan. Most employees are familiar with these plans. Employers routinely offer these plans nationwide.
The IRS established annually maximum contributions that typically adjust annually. Since the employee is generally contributing their own money, they bear all the investment risk. The plan assets can go up or down. The employee gets all the upside and of course the downside.
Characteristics of 401ks & Defined Contribution Plans
A defined contribution plan maintains an account balance for each participant. This contribution is “owned” by the employee. He or she is entitled to their account balance upon retirement or termination.
Contributions are made to the plan each year and allocated in some nondiscriminatory manner specified in the plan document. Depending on the type of plan, the contributions may or may not be required.
Most often the contribution is discretionary. Other examples of defined contribution plans are profit sharing, money purchase, stock bonus, employee stock ownership, target benefit, 403(b) and 457 plans.
Most profit sharing plans do not have a required contribution. Employee contributions are allocated to the participant accounts in accordance with the plan document.
What about the benefit allocation?
Generally, each employee contribution is segregated into a “sub account.” The ultimate benefit the participant receives from a defined contribution plan is based entirely on the participant’s account balance. For this reason, the participant bears the risk of investment, since low investment returns will result in a smaller benefit at retirement.
As stated, the employer does not guarantee the benefits under a defined contribution plan. A defined contribution plan generally favors younger employees. This is because money invested over a long period of time tends to accumulate to large amounts.
Can you have a cash balance plan and a 401k?
Yes you can. The two plans can be combined to increase the overall contribution amount. Many will include a profit-sharing component with a 401(k) plan and a business can add a cash balance plan too.
In fact, probably 80% to 90% of our cash balance plans have a 401(k) plan as well. Most companies start with a 401(k) when they are first in the market for a retirement plan. Once they desire a larger contribution level they will move up to the cash balance plan. But they keep the current 401(k) plan they have even though they may have a plan amendment. Both plans can really work great together.
Cash balance plan vs 401k
Many companies combine a cash balance plan with other qualified plans in order to meet their retirement contribution goals. In most situations, an employer will combine a 401k Profit Sharing plan in conjunction with a cash balance plan. This will enable the employer to generate sizable retirement contributions for the owner and employees.
The employer contributes a percentage of the employee’s yearly compensation plus interest charges to a “hypothetical account”. But they do not have an actual separate account for each employee.
The sponsored investment firm manages the investments of this account on a regular basis, investing the funds based on the company’s risk tolerance and investment objectives.
When the employee decides to retire, they have the option to take a lump sum of the contributions, or to receive guaranteed monthly payouts in the form of a life annuity.
You don’t pay taxes on any funds contributed right now, and only pay taxes upon withdrawal of funds as ordinary income.
This makes cash balance plans very attractive to employers with a large number of employees, allowing the employer to deduct a potentially large amount of money contributed to each employee’s cash balance plan.
The Case for the Cash Balance Plan
- A 401k plan has a separate account for each employee who wishes to contribute, where a cash balance plan has one trust account, and a “hypothetical account” for each participant.
- Cash balance plans are qualified plans and offer larger contributions with larger tax deductions.
- 401k plans have annual contribution limits and cash balance plans contribution limits are dependent upon the participants age, allowing those nearing retirement to contribute more.
The Case for the 401K
- A 401k plan gives each participant a list of potential funds to choose from, allowing the participant to invest their money as desired.
- Cash balance plan costs are higher are more expensive to set up and administer. This, in part, is the result of the need for actuarial review of the plan annually. However, cash balance plans can be much more cost effective considering the significant contributions. Many 401k plans have hidden fees that add to plan administration costs.
How to determine which plan is right for you
We’ll answer below some of the basic questions regarding these two plans.
How to determine which plan is right for you
- Determine how much you want to contribute. If you are looking to get say $20,000 into a plan then a 401k would be your best bet. But if you are looking to contribute over $100,000 then a cash balance plan might be best.
- Consider how consistent your cash flows are in the near future. Remember that solo 401k plans are elective, but cash balance plans are permanent. If you look out over the next several years and you expect high profits then a cash balance plan might be the right choice. But if your profits fluctuate widely then you might stick with a 401k.
- How sensitive are you to the cost of the plan? 401k plans will cost very little to administer. But cash balance plans will cost approximately $2,000 a year to administer. The higher fees are fine if you are making large contributions. So make sure that you consider the cost benefit.
- Consult your CPA or financial advisor. Do you have a financial advisor or tax professional that you trust? Consult with him or her to see what they think. Your CPA is in a great position to determine the tax impact of any contribution.
- Make your decision before the deadline. Don’t forget. The deadline to set up each plan is December 31st (for a calendar year). Make sure to make a decision before it’s too late.
Both cash balance plans and 401k plans have many similarities for example in the payout options and the tax benefits. Each have unique benefits for employers who wish to offer them, and for employees who wish to participate.
At the end of the day, if you only want to contribute a rather small amount like $30,000 or so and you want a cheap and easy plan then stick with the 401k. But if you want to put $100,000 plus into retirement (like most of our clients) then go with the cash balance plan.
So take a look at both plan structures and chose a plan that works for you!