Cash Balance Plans: The Beginners Guide [Rules, Benefits + FAQs]

What is a cash balance plan? You may have heard that it is a great retirement structure. But you may not know a lot about the rules and how they work.

It is often referred to as the #1 retirement strategy for business owners. But before you set up a plan, you should carefully examine the benefits and pitfalls.

In this post, we will show you how these plans work. We also have some videos and three examples that will explain some of the important rules and requirements. Let’s jump in!

What is a cash balance plan?

A cash balance plan is technically a defined benefit plan structure. It defines the retirement benefit using a “hypothetical account” that is similar to a defined contribution plan. Said differently, a cash balance plan states the final benefit using this account balance.

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What is a Cash Balance Plan?

A cash balance retirement plan is special type of retirement structure that allows business owners to make large tax-deductible contributions. You can think of it as a 401(k) plan on steroids. In fact, annual contributions can exceed $300,000.

A cash balance plan presents the benefit similar to a defined contribution plan. It is called a “hybrid” plan because it specifies the benefit as an actual account balance.

In the right situation, they can be a home run. There just are not that many structures that you can contribute 6 figures and get a full tax deduction.

Many business owners are searching for tax deferral strategies and a way to accelerate their retirement savings. These plans address these two issues.

How do cash balance plans work?

A cash balance pension plan establishes a “hypothetical account” for each plan participant. The third-party administrator (or “TPA”) accounts for the hypothetical accounts.

The hypothetical account can usually be paid out as a lump-sum withdrawal to a participant upon disability, death, retirement, or even termination of service.

If the account value exceeds $5,000, the employee can elect an annuity instead of a lump sum distribution. For this purpose, hypothetical accounts in a cash balance plan are valued using rates of interest and mortality prescribed by the IRS.

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If assets are insufficient, the employee might only receive the annuity or wait until assets are enough to make a lump sum distribution. If you deposit the recommended or target contribution annually, such restrictions will rarely occur.

Contributions driven largely by age

So here is what’s special about these plans. All things being equal, the older you get the more you can contribute and the larger the tax deductions. As a result, allowable contributions will increase with age.

Here’s how it works. Let’s assume there are two employees who both make $50,000 a year. One employee is 35 years old and the other is 55 years old. In theory, they both should have the same retirement benefit at age 62.

Only a small contribution is required because the 35-year-old has many years until retirement. But the 55-year-old just has 7 years to hit the plan retirement age. As such, you can make a much larger contribution.

So therein lies the beauty of the plan. Most high-income self-employed people tend to get more serious about retirement (and have more money) when they are in their mid-forties and fifties. Annual contributions in the age range can often exceed $100,000 annually.

Participant interest credits

The hypothetical accounts of the plan participants are credited with a guaranteed interest rate stated in the plan document. The excess will reduce future employer contributions if the trust earnings exceed the guaranteed rate.

The participant accounts are not affected. The accounts will increase according to the plan document, and the increase will be funded partially by employer contributions and partially by excess earnings.

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The employer’s contribution will typically differ from the amounts added to the participant accounts. This difference is mainly due to variations between the interest credited to the participant accounts and the return on the plan’s investments. Additionally, it can be influenced by vesting or changes in IRS-required assumptions, providing a comprehensive view of the factors influencing your retirement savings.

Can plans be combined with other retirement structures?

As an employer, you have the option to combine a 401(k) profit-sharing plan with the cash balance plan. As an owner, you can decide how much you want to contribute based on your company’s profits at year-end.

If you set up your account as a safe harbor plan, you’ll need to make a contribution each year. It doesn’t matter what your profits are – you must contribute the amount stated, typically around 4%.

Fortunately, you can deduct the safe harbor amount from the profit-sharing amount, reducing the amount you must contribute.

How can I customize a cash balance pension plan?

The good news is that there is some flexibility in plan design rules. These plans can be customized to slant in favor of the business owner.

The plan administrator (or TPA) can run multiple illustrations to compare different plan options. For example, the company can contribute different amounts for different participants.

Funding reductions are not allowed when employees reach 1,000 service hours. Plans can be terminated or frozen. But only before employees reach 1,000 hours. This is the case only if the company does not want to make a contribution for the current year.

Is a cash balance retirement plan a qualified plan?

Yes, cash balance plans are qualified plans. This means they are subject to the same regulations and tax benefits as other retirement plans, such as 401(k) plans, SEPs and IRAs.

To be classified as a qualified plan, a plan must meet specific requirements, such as:

• It must be established and maintained by an employer.
• It must provide benefits to all eligible employees.
• It must meet specific funding requirements.
• It must comply with certain rules about discrimination.

Cash balance plans meet all of these requirements. As such, they are qualified plans and offer the same tax benefits as other retirement plans.

Tax Benefits and Plan Features

These plans have a lot of benefits. So, let’s take a look:

• They are not subject to the traditional contribution limits and retirement rules associated with 401(k) plans.
• They are “qualified” plans, which means that they qualify for tax deferral status.
• Qualified plans offer creditor protection. This protection comes under ERISA.
• They are generally protected from bankruptcy and lawsuits.
• They work great for sole proprietors, S-corps and C-corps and other structures.
• They can be combined with other retirement structures, such as a 401(k).
• A solo plan or one person plan can use the Mega Backdoor Roth.
• They allow for portability. The employee can roll the funds into an IRA.
• Did I mention that contributions are tax deductible?

What are the pitfalls associated with cash balance pension plans?

But those large contributions come with a price. These plans are more complex and more expensive to administer. Ensure that your financial planner and CPA are on board. Most don’t understand how they work.

Like any plan, there are some disadvantages. Let go through them:

• Cash balance retirement plans are permanent, and contributions are not elective.
• You should keep them open for at least 3 years. You can terminate for good cause.
• An actuary must review and certify plans each year.
• They are expensive retirement plans to administer. Most plans will run $2,000 or more annually.
• The plans often have rules and restrictions on the lump sum payment options.

What companies are best suited?

Now that you understand the basics, let’s look closely at the companies that are great candidates for these plans. As a general rule, a company should have the following qualities:

1. Consistent cash flows and high profits.
2. High marginal federal and state tax rates.
3. The goal of aggressively accumulating retirement savings.
4. The desire to get large retirement tax deductions.
5. The motivation to “catch-up” on retirement planning.

The ability to contribute a larger amount per year based on each individual’s age, make a cash balance defined benefit plan very attractive for any small business owner.

But be careful. Many small business owners want to re-invest as much of the business profit back into the company. 

Others who may benefit from plans are (for example):

• Companies with large income streams and the ability to contribute the minimums to a cash balance plan.
• Companies who want to combine retirement structures and seek bankruptcy and creditor protection.
• Companies wanting to provide an attractive employee benefit to motivate staff who play a key role in the company.

Rules and Requirements

So let’s start with understanding some retirement basics. Retirement plans are classified into two main categories: defined benefit plans and defined contribution plans.

Defined benefit plans look to generate a specific benefit at retirement. However, defined contribution plans work a little differently. They specify a maximum contribution limit upfront.

You know how a 401(k) establishes maximum annual contributions? That’s because it falls under the defined contribution category. In contrast, a cash balance plan falls under the define benefit plan retirement category.

A 401(k) has an annual employee maximum contribution. Once you contribute, the account can grow to $1 million, or it could go to zero. For plan purposes, it doesn’t matter.

What are the retirement eligibility and vesting rules?

Before you ask what a cash balance plan is, you need to understand how a defined benefit plan works. But a cash balance retirement plan doesn’t have that same annual limit rules like the 401(k) plan does. It is actually trying to contribute enough money so that you have a specific account balance when you retire (typically at age 62).

How much money you have when you retire is dependent on a few things. But most importantly, it is how much compensation you were paid over the years.

Small companies who operate as sole proprietorships (and have no employees) are certainly able to set up cash balance plans. We typically refer to these plans as solo or one person plans.

The business owner can establish a plan and provide funding for just himself or herself and may also be able to contribute for a spouse that works at the company.

Please note that the basic 401(k) plan (with profit-sharing) allows a profit-sharing maximum contribution of 25%. But when the plan is combined with a cash balance plan it is limited to only 6% (subject to other rules).

Assuming you meet the criteria, you can have approximately $3 million when you retire. You get the point. It’s a nice nest egg.

What are the risks I should consider?

The company should always discuss the pros and cons of any new retirement plan up front. Since each plan type has different features, it is helpful for the advisor or benefit consultant to compare and contrast the most important features between plans.

Financial and legal risks are a prime consideration, and these can be managed by ensuring compliance tests and government filings are completed accurately and timely.

If assets return more than expected, the employer contribution will decrease (all other assumptions being satisfied). On the other hand, poor returns require increasing employer contributions.

Contribution Limits

Basically, all retirement vehicles have some form of contribution limit. Cash balance plans are really no different.

As stated previously, contribution limits are highly dependent upon employee age. The table below is meant to give you a general idea of contribution limit based on age.

How much can I contribute to a cash balance pension plan?

But please realize that these are estimated amounts and final numbers are determined by an actuary. So, use these as a guideline and not as a rule:

Here’s a tip to get a bit more into a plan. A new plan (one that is not a conversion of an existing defined benefit plan) can grant “past” or “prior” service in the form of an opening cash balance credit. These rules allow for a larger plan contribution in year one.

Business owners do enjoy some flexibility under a cash balance pension plan. The owner has some control over which employees they can contribute for and how much (subject to IRS non-discrimination rules).

Investment Options

Many people think that the third-party administrator who sets up the plan will also manage the retirement plan assets. Alternatively, they often believe that they must contribute their funds into a specific investment vehicle. This is far from the truth.

Most companies will open up an account with their financial advisor or a traditional discount broker like Charles Schwab, Fidelity, Etrade or Vanguard. We have relationships with all the large retirement custodians to help expedite the plan set-up process.

These plans do not have to have a “special” account. The reality is that the plan establishes a trust. This example trust is similar to what you would have with a 401(k) plan.

Plans can invest in stocks, bonds and mutual funds. This is similar to a 401(k) plan. Employees cannot chose individual assets as all funds are in a pooled account.

Take a look at the video below to understand your investment options:

Withdrawals and Distributions

Here are some common ways to withdraw or distribute money from a cash balance plan:

1. Lump sum distribution: This is a one-time payment of the participant’s entire account balance, usually payable at retirement or when the participant leaves the employer. The payment is generally rolled into an IRA or another qualified retirement plan.
2. Annuity payment: This is a series of regular payments made to the participant for the rest of their life, based on the amount of their account balance and the plan’s annuity factors.
3. Partial distribution: This is a partial payment of the participant’s account balance, usually paid as a lump sum. The remaining balance stays in the plan and earns interest until the participant decides to take another distribution.
4. Rollover to an IRA: A participant may roll over their cash balance retirement plan account balance into an IRA or another qualified retirement plan. This allows the participant to defer taxes on the account balance and earn tax-deferred interest.

What if I want to terminate the retirement plan?

A cash balance pension plan meets the definition of a defined benefit plan. The employer bears the cost of contributing to the pension.

At retirement, the employee may choose to accept the vested benefit as a lump sum distribution. The employee may also roll the plan into an IRA to allow the monies to continue to accrue interest.

Should an employee leave the company before retiring, he or she may request a distribution of the vested account balance. Alternatively, they may roll the entire fund into an IRA.

Under a traditional pension plan, employees do not have the option to roll funds over. Instead, they will receive a reduced annuity or a lump sum when they finally retire.

There are many steps in the termination process. Take a look at the video below for an example:

How does the formula work?

Let’s look at an example of how the pay credit formula works. You don’t have to be a CPA to understand how it works (but it might help). Here is the easy five-step process:

• Beginning of the year balance is $10,000
• Interest crediting rate is 4%
• W2 compensation of $100,000
• Pay credit is based on 5% of pay
• End of year balance is ($10,000 × 1.04) + ($100,000 × 5%) = $15,400

Remember that the hypothetical account balance is simply a bookkeeping example utilized to track each participant’s account balance. It does not tie directly to the plan’s asset balance.

How to Set Up a Plan

Who Manages a Cash Balance Plan?

The plan sponsor manages a cash balance plan. The plan sponsor is the employer who establishes and maintains the plan. The plan sponsor is responsible for making contributions to the plan, investing the plan assets, and providing benefits to employees.

The plan sponsor can hire a third-party administrator to help manage the plan. A third-party administrator (TPA) is a company that provides administrative services to retirement plans. Third-party administrators can help with tasks such as:

• Processing contributions
• Investing assets
• Distributing benefits
• Reporting to the IRS

The plan sponsor is ultimately responsible for the plan, even if they hire a third-party administrator.

Final Thoughts

Cash balance plans are becoming increasingly popular, and they are great plans for the self-employed. With many business owners looking for significant tax deductions, asset protection, and the ability to make sizable retirement contributions, cash balance plans make great options.

Through pension reforms over the years, the plans have become more flexible and offer streamlined administration. Make sure you consider them in your retirement arsenal. Hopefully, this cash balance plan guide and example has helped you understand the basics.