What is a cash balance plan and who is it for?
A cash balance plan is a defined benefit plan that shows each participant a stated account balance, funded toward a future benefit rather than a yearly contribution cap. Owners with high, stable income use it to make far larger deductible contributions than a 401(k) allows, often stacking one on top of the other. An enrolled actuary certifies the funding each year.
Key points
- A cash balance plan is a defined benefit plan that credits each participant with a stated account balance grown by an annual pay credit and interest credit.
- Because a cash balance plan is funded toward a targeted retirement benefit, its allowable annual contribution can be several times larger than a 401(k) permits.
- Older owners can contribute the most to a cash balance plan because more must be set aside each year to reach the target by retirement.
- An enrolled actuary calculates and certifies the required cash balance contribution every year, which makes the plan a multi-year funding commitment.
- Cash balance plans must pass nondiscrimination testing, which generally requires a meaningful contribution for eligible employees.
How does a cash balance plan work?
A cash balance plan is a type of defined benefit plan designed to feel familiar. Instead of promising a monthly pension at retirement, it credits each participant with a stated account balance that grows by a set pay credit and an interest credit each year. Participants see a balance they understand, while the plan is funded and tested like a traditional pension.
The business sponsors the plan, and an enrolled actuary calculates the required contribution each year from the participant census, the ages of the participants, and the targeted benefit. The employer deducts the contribution, and the balances grow tax-deferred until distribution.
Why can an owner contribute so much more than a 401(k) allows?
Defined contribution plans, such as a 401(k) with profit sharing, cap what can be added each year. A cash balance plan is funded toward a targeted benefit at retirement, so the allowable annual contribution can be several times larger, particularly for an owner who is older than most of the staff. The closer a participant is to retirement, the more must be set aside each year to reach the target, which works in the owner's favor.
Cash balance plans are frequently stacked with a 401(k) with profit sharing. The 401(k) captures salary deferrals and a profit-sharing contribution, and the cash balance plan sits above it to absorb the larger amounts. Combined, the two can move a substantial sum into tax-deferred savings each year for an owner who wants to contribute aggressively.
Who is a cash balance plan for?
The plan fits a specific profile. Income should be high and, just as important, stable. Because an enrolled actuary calculates a required contribution each year, this is a multi-year commitment rather than a one-time move. Physicians, dentists, attorneys, and owners of firms with dependable cash flow are the typical sponsors.
The plan is also most attractive when the owner is older than most employees, since the age-weighted funding then favors the owner. A younger owner with a large, older staff will find the design far less efficient.
What are the costs and limits?
The trade-off is staff cost and testing. These plans must satisfy nondiscrimination rules, which generally means providing a meaningful contribution to eligible employees. A plan designer and the enrolled actuary run the testing each year to keep the arrangement qualified and to balance the benefit to owners against the cost of covering staff. The design is engineered to your census, not improvised.
A business with volatile earnings can find the required funding uncomfortable in a down year, and underfunding a defined benefit plan carries its own excise tax. The actuary certifies the funding annually, files the required schedules, and confirms the plan remains on track; that certification is part of what makes the large deduction defensible. Adopt the plan before the deadline, fund it as the actuary directs, and keep the plan documents current.
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Sources
Related guides: high income professionals, medical practices, dental
Mena Hemaia, CPA, CIA
Chief Executive Officer, Accountack — West Palm Beach, Florida
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