The downside of the most popular tax-advantaged retirement plans, like 401(k) and profit sharing plans, is that they restrict how much can be contributed. This can hamper retirement planning efforts for more highly compensated individuals. Business owners in particular may find that they can’t set aside as much as they would like, especially as they age and (hopefully) start to earn more. A cash balance plan may be an option for those in this situation.
Defined benefit plan with a twist
The two most common qualified retirement plans — 401(k) and profit-sharing plans — are defined contribution plans. These plans specify the amount that goes into an employee’s retirement account today, typically a percentage of compensation or a specific dollar amount.
In contrast, a cash balance plan is a defined benefit plan, which specifies the amount a participant will receive in retirement. But unlike traditional defined benefit plans, such as pensions, cash balance plans express those benefits in the form of a 401(k)-style account balance, rather than a formula tied to years of service and salary history.
The plan allocates annual “pay credits” and “interest credits” to hypothetical employee accounts. This allows participants to earn benefits more uniformly over their careers, and provides a clearer picture of benefits than a traditional pension plan.
Greater savings for owners
A cash balance plan offers significant advantages for business owners — particularly those who are behind on their retirement saving and whose employees are younger and lower-paid. In 2017, the IRS limits employer contributions and employee deferrals to defined contribution plans to $54,000 ($60,000 for employees age 50 or older). And nondiscrimination rules, which prevent a plan from unfairly favoring highly compensated employees (HCEs), can reduce an owner’s contributions even further.
But cash balance plans aren’t bound by these limits. Instead, as defined benefit plans, they’re subject to a cap on annual benefit payouts in retirement (currently, $215,000), and the nondiscrimination rules require that only benefits for HCEs and non-HCEs be comparable.
Contributions may be as high as necessary to fund those benefits. Therefore, a company may make sizable contributions on behalf of owner/employees approaching retirement (often as much as three or four times defined contribution limits), and relatively smaller contributions on behalf of younger, lower-paid employees.
There are some potential risks. The most notable one is that, unlike with profit-sharing plans, you can’t reduce or suspend contributions during difficult years. So, before implementing a cash balance plan, it’s critical to ensure that your company’s cash flow will be steady enough to meet its funding obligations.
Cash balance plans are typically more expensive than defined contribution plans, but the boost in retirement savings for certain individuals can easily offset that expense. If you have questions or want to discuss whether a cash balance plan is right for you, JLK Rosenberger can help. For more information, call us at 949-860-9902 or click here to contact us.