Well-designed retirement plans can generate enormous wealth for a business owner at retirement. Unfortunately, complex rules, confusing terminology and mathematically driven formulas tend to scare off many who could benefit from them. One such example is a cash balance plan. Here, I’ll explain, in a nutshell, the features and advantages of a cash balance plan, and how it can help build wealth when combined with a 401(k) plan.
What Is A Cash Balance Plan?
A cash balance plan is a defined benefit plan that, in some ways, resembles a 401(k) plan. Like 401(k) plans, typically cash balance plans credit a participant’s hypothetical account annually with a “pay credit” (such as 5% of the employee’s compensation) and an “interest credit” (this rate can be fixed or variable linked to an index). The plan participant account is referred to as a “hypothetical” account because the plan administrator maintains the accounts for each participant. Unlike 401(k) plans, those hypothetical accounts are then used to determine the monthly benefit the eligible employee will receive at retirement. Also, unlike 401(k) plans, changes in the actual value of the plan’s investments are the employer’s responsibility and do not directly impact the amounts participants receive.
In a cash balance plan, the rules do not limit the annual contribution amount but instead limit the ultimate benefit payable from the plan. The current maximum benefit is a life annuity of $230,000 per year payable beginning at age 62, subject to adjustments based on age, years of service and participation. The lump sum equivalent of that benefit at retirement age is over $2 million. So you can see cash balance plans offer the potential to generate considerable retirement savings that can be several times that of 401(k) profit-sharing plans alone.
The primary advantage of establishing a cash balance plan is the ability to generate high annual tax deductions and create long-term retirement wealth through the power of tax deferral. However, there are several disadvantages to establishing a cash balance plan. The first is cost. A cash balance plan typically costs more than a 401(k) plan to set up and administer. In addition, cash balance plans do not offer employees the right to direct their own investment choices. Each year, the employee would receive a statement of their contributions and return on investment.
How Does A Cash Balance/401(k) Combo Plan Work?
For those business owners who are seeking to make annual plan contributions in excess of the stated 401(k) limitations, sponsoring a cash balance plan, in addition to a 401(k) plan, is an option. For example, for a 50-year-old business owner with annual compensation of $285,000 or more, combining a cash balance plan with a 401(k) plan increases the potential maximum annual tax deductible plan contribution from $63,500 up to $207,000.
The ideal candidate for a combo plan is a highly compensated business owner who is seeking larger contributions and greater tax deductions. The business should anticipate consistent profits and strong cash flow for a number of years for a couple of reasons. The first reason is because retirement plans are supposed to be permanent. Although there is not an objective standard of permanency, three to five years appears to be sufficient time to satisfy the permanency requirement. Secondly, cash balance plans are not profit-sharing plans. Annual plan contributions are required and are calculated by an actuary in order to cover top heavy, minimum gateway and non-discrimination testing requirements.
Here is an example that illustrates the power of a cash balance plan combined with a 401(k) plan.
ABC Inc. has two owners and four employees:
• Owner A is 60 years old and earns $285,000.
• Owner B is 45 and also earns $285,000.
• Employee 1 is 40 and earns $75,000.
• Employee 2 is 35 and earns $50,000.
• Employee 3 is 30 and earns $40,000.
• Employee 4 is 25 and earns $30,000.
ABC’s owners want to make high annual retirement contributions above the 401(k) plan allowances, and after speaking with a third-party administrator, they decided to establish a combo cash balance/401(k) plan. Here is an estimation of how much the owners of ABC Inc. will be able to defer in 2020:
Owner A can contribute a maximum of $63,500 to the 401(k) plan, which is the maximum amount for 2020 based on his age. This includes $26,000 for the employee deferral, a 3% contribution in a safe harbor plan of $8,550 and an employer contribution of $28,950. He will then receive a cash balance credit of $266,848 (based on actuary calculations) for a grand total of $330,348.
Owner B can contribute $19,500 to the 401(k) plan as an employee, with the same safe harbor and employer contributions as Owner A, plus a cash balance credit of $126,492 for a total of $183,492.
The employees will have varying safe harbor and employer contributions based on their salaries. In addition, they would each receive a $700 cash balance credit.
The total retirement savings for each employee is as follows:
• Employee 1: $6,145
• Employee 2: $3,330
• Employee 3: $3,604
• Employee 4: $2,878
In this example, both Owners A and B will be able to max out their 401(k) plan and make high annual cash balance contributions, while creating significant tax deductions and incurring minimal cash expenses for cash contributions made to their four employees. The actuary will determine the minimum and maximum defined benefit contribution and deduction allowed under the plan.
Choosing the right retirement plan for your small business can be a $2 million decision. If you are highly compensated and your financial goals include saving as much as you can for retirement, the cash balance/401(k) plan combo might be the solution for you. However, it’s important to work with a cash balance plan specialist who can design the best retirement plan for you and your business.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.