Cash Balance Plan (FAQ)

By:  Scott Cloud, MBA, CPC

Cash balance plans are a type of defined benefit retirement savings plan that enables business owners to make significant tax-deductible contributions each year and to accumulate significant retirement savings on a tax-deferred basis. While SEPs and 401(k)/profit sharing plans – as defined contribution retirement plans – limit total annual contributions to $66,000 (indexed), annual contributions to a cash balance plan generally depend on the owner’s age and income and often exceed $200,000.

Below is a listing of some of the most common questions asked by business owners and their financial advisors, accountants, and attorneys in determining whether a cash balance plan might be a good fit in meeting retirement savings and tax planning goals.

What is a cash balance plan and how does it differ from a traditional 401(k) plan?

As with a traditional 401(k) plan, a cash balance plan is a type of tax-qualified, employer-sponsored retirement savings plan. By satisfying the provisions of Section 401(a) of the Internal Revenue Code, qualified retirement savings plans provide for tax-deductible contributions, tax-deferred growth of plan investments, and protections from creditors for both the employer and its employees.

A 401(k) plan is a “defined contribution plan”, whereby each eligible participant is able to elect to have “salary deferral” amounts withheld from their paychecks and contributed to their account in the plan on a tax-deferred basis and the employer is able – on a discretionary basis – to fund employer-contributed amounts to participant accounts in the plan. The retirement benefits that are payable to a participant in a 401(k) plan are not guaranteed, but instead depend on the contributions made and the performance of the investments over the life of the participant’s retirement savings account.

A cash balance plan is a type of “defined benefit plan”, whereby the plan is entirely employer-funded and the contribution/benefit formula for participants is clearly defined by the plan. A “traditional” defined benefit plan expresses the participant’s retirement benefit as a monthly annuity payable at retirement, which can be somewhat confusing because the current value of the participant’s accrued benefit isn’t readily apparent. While a cash balance plan is technically identified by the IRS as a defined benefit plan due to the contribution/benefit formula being clearly defined by the plan, it is generally viewed as a “hybrid” between a defined benefit plan and a defined contribution plan because each participant’s benefit is expressed in terms of a current account balance (similar to with a 401(k) plan). In addition to receiving an annual contribution credit, each participant in a cash balance plan also receives an annual “fixed interest credit”. A participant’s balance in a cash balance plan, therefore increases each year by the amount of their contribution credit and their fixed interest credit.

How are the assets invested in a cash balance plan?

Unlike in a 401(k) plan, the assets in a cash balance plan are not maintained in separate accounts for plan participants, and participants cannot direct their own investments. Instead, the assets in a cash balance plan are invested in a “pooled” Trust account that is maintained in the name of the plan and that is managed by the plan’s investment advisor. The cash balance plan Trust therefore acts as the investment vehicle that is funded annually by the employer and managed by the plan’s investment advisor to pay out benefits based on the “cash balance” being tracked for each participant in the plan.

The assets in the cash balance plan Trust are managed in a conservative manner in order to 1) avoid the possibility of large losses affecting the plan’s ability to pay out benefits when the time comes, and 2) prevent the plan from becoming overfunded (whereby the growth of the cash balance plan Trust out-paces the growth of “cash balances” being tracked for participants, which can limit the employer’s future tax-deductible contributions to the plan). A typical cash balance plan Trust targets an annual return of approximately 5%.

How are amounts funded to a cash balance plan (and how much)?

One significant difference between a 401(k) plan and a cash balance plan is that there is an individual lifetime benefit limit in a cash balance plan. While a 401(k) plan can be funded up to the maximum annual IRS plan contribution limit of approximately $66,000 each year (and with no limit to the number of funding years for each participant), it takes at least 10 years to fund the maximum lifetime benefit limit for business owners in a cash balance plan. For a business owner who wishes to fund the maximum lifetime benefit limit to a cash balance plan, the business owner’s annual tax-deductible contributions to the cash balance plan are typically in the range of $100,000 – $300,000 each year (depending on the business owner’s age and annual income).

The amount that the employer is required to fund to the plan is fairly consistent from one year to the next, although the employer does have some funding flexibility – in the form of an annual “funding range” – as long as the plan remains “fully-funded” each year.

What tax advantages do cash balance plans provide?

Since contributions to a cash balance plan are tax-deductible to the sponsoring employer (or sole proprietor), significant tax savings are realized starting with the first year the plan is adopted. For instance, a $100,000 cash balance plan contribution would immediately save $35,000 in federal taxes for a business owner in the 35% federal tax bracket. The tax savings would be even higher for those living in states with an income tax. That $100,000 cash balance plan contribution then grows on a tax-deferred basis in the cash balance plan’s Trust account. Compare this to the growth of an after-tax amount of $65,000 ($100,000-$35,000) contributed to a regular brokerage account, which is taxed each year for earned dividends, interest, and realized capital gains.

It should be noted that the benefits accrued in a cash balance plan are subject to income taxation when they are withdrawn during retirement. So, part of optimizing the tax benefits of maintaining a cash balance plan is evaluating your future tax situation.

What is the maximum lifetime funding limit for a cash balance plan?

In an ideal scenario, for a business owner funding a cash balance plan up to the IRS maximum lifetime funding limit, the funding would typically take place over a period of 10 to 12 years ending at age 65 or later, and the “cash balance” at the time the maximum lifetime funding limit is reached would be approximately $3.4 million. This $3.4 million figure is a combination of principal (the annual tax-deductible contributions) and interest (annual “fixed interest credits”) and would be discounted for a business owner for whom the lifetime limit is reached prior to age 65.

Can an employer maintain a cash balance plan and a 401(k) plan?

Yes. In fact, many employers who maintain a cash balance plan also maintain a 401(k) plan. In some cases, this is done to add additional retirement savings for owners of the employer. When the sponsoring entity has employees, a 401(k) plan is also maintained to assist with employee recruiting and retention.

If a cash balance plan sponsor has employees, what will be the funding obligation for employees?

A cash balance plan can use an eligibility age requirement of up to 21 and an eligibility waiting period of up to one year for new hires (with plan entry on the following January 1 or July 1).  While some employees can be excluded from a cash balance plan, in general the plan must “cover” at least 40% of all owners + employees who have met the eligibility requirements (but no fewer than two if at least two have met the eligibility requirements).  Contributions to a cash balance plan must satisfy IRS “nondiscrimination” testing requirements.  If eligible employees tend to be younger than the owner(s), the testing is age-based; allowing for a lower contribution percentage for employees than for owners.  The contribution requirement for employees is determined by IRS nondiscrimination testing rules; it is not based on a set dollar amount or contribution percentage but rather the dollar amount or percentage that is needed to pass testing.  In addition, if the employer maintains a 401(k)/profit-sharing plan alongside the cash balance plan (which is often the case), employer contributions to both plans are aggregated for testing purposes.  In an ideal scenario in which there is an appreciable age gap between the owner(s) and employees, as a general rule of thumb employees will require a total employer contribution that is equal to 9% of their total wages (2% as cash balance and 7% as profit sharing).

Can a cash balance plan use a vesting schedule?

Yes.  Most cash balance plans use a three-year “cliff” vesting schedule whereby an employee is 0% vested until they’ve completed three years of service with the employer, and the employee becomes 100% vested upon completion of three years of service (a year of vesting service is defined as a Plan Year during which the employee completes at least 1,000 hours of service).  With a three-year vesting schedule, if an employee terminates employment prior to completing three years of vesting service their entire balance will be “forfeited” and used to offset/reduce the employer’s future cash balance contribution expense.  If the employer would like, it can certainly use a vesting schedule that is shorter than three years.  (It should be noted that vesting is based on total years of service with the employer; a “rolling” vesting schedule does not apply to each year’s cash balance contribution.)

What is the deadline to establish a new cash balance plan?

Prior to 2020, a new cash balance plan was required to be adopted by the last day of the plan’s initial year. Starting in 2020, the SECURE Act made it so that business owners can adopt a cash balance plan right up until the entity’s tax filing deadline (including extensions) for the plan’s initial year. It typically takes several weeks to prepare the plan documents, set up the plan’s Trust account, calculate Year 1 contributions, and fund Year 1 contributions to the Trust account by the entity’s tax filing deadline, so for practical purposes it is recommended that business owners start working with an actuarial services firm at least two months prior to the entity’s tax filing deadline for the plan’s initial year.

To learn more about Cash Balance Plan, please contact The Retirement Plan Company, LLC.