Cash Balance Plan Benefits —and Their Trade-offs

401(k) | Retirement Planning | Taxes & Tax Planning | Business Strategy | Retirement Tax Planning | Tax Strategy | High/Ultra High Net Worth | Investment Strategy

 Matt Baisden By: Matt Baisden

As a retirement plan advisor, I help business owners come up with the right mix of benefits to build a secure retirement for themselves and their employees. Yet there are so many options beyond the familiar 401(k) plan that busy owners can struggle to keep all the details straight. One option that often raises questions is called a cash balance plan—but much of the confusion I see stems from the difference between how the retirement plan industry markets these plans and business owners’ initial impressions of them.

What are cash balance plans?

Cash balance plans are a type of defined benefit plan in which the company makes contributions on behalf of all participants. What sets these plans apart is they offer much higher contribution limits than a 401(k)—especially for older participants, who can contribute more than $200,000 a year after age 55—and provide a guaranteed retirement benefit. A participant’s contributions also grow tax-deferred at a set interest rate, typically 4% to 5%, rather than based on investment performance.

Some consultants marketing cash balance plans talk up the perks and make them sound incredible: Save more than $200,000 a year! Get amazing tax breaks! It sounds like a great idea to many owners—until they dig into the details. That’s when they find out you have to make a big commitment to funding that plan and need to rely on a bit more professional oversight and management to avoid running afoul of IRS rules. These complications often lead business owners to assume the plans are too complicated and burdensome.

The truth, though, is somewhere in the middle. For the right business, cash balance plans can be a great fit, and a good complement to a 401(k). The advantages are real—but so are the commitments. So to help clients make an informed decision, I rely on straight talk about the pros and cons. Here are the three key benefits of cash balance plans—and their tradeoffs

1. Cash balance plans allow you to save a lot and get big tax deductions.

Benefit:

Cash balance plan contribution limits increase with age. But no matter how old you are, the limits for a cash balance plan are always higher than those for a 401(k). Compare the maximum contributions for 2020:

Age

401(k)

Cash balance

60-65

$63,500

$281,000

55-59

$63,500

$230,000

50-54

$63,500

$179,000

45-49

$57,000

$140,000

40-44

$57,000

$109,000

35-39

$57,000

$85,000

30-34

$57,000

$66,000

 

Companies make those contributions on behalf of plan participants, so the amount is deductible to the company. For owners, those tax savings can flow through to their individual tax returns. And like other retirement plans, savings grow tax deferred, giving participants a potentially bigger pool of funds down the road. It’s also important to note that you can have both a 401(k) and a cash balance plan, and can contribute the maximum to both—so a 55-year-old, for example, could save a total of $293,500. 

The tradeoff: Cash balance plans are a big commitment.

The IRS wants your plan to be in place for at least five to seven years, and it asks that contributions remain similar throughout that time. It may be possible to change contributions under certain circumstances, but it requires a documented business reason.

What’s more, you have to cover 40% of your workforce, or up to 50 participants. And you likely need to commit to giving covered employees between 5% to 7.5% of their salary.

These rules make cash balance plans a better fit for small businesses with an owner and a few employees, or for law or medical firms that can cover both partners and lower-paid administrative employees.  

2. Plan participants receive a guaranteed benefit.

Benefit:

Unlike other retirement plans, where a participant’s account balance can decline, savings in a cash balance plan don’t fluctuate based on investment performance. Instead, there’s a set an interest crediting rate—typically 4% or 5% annually—and participants receive contributions plus that growth when they retire. To achieve that rate, the plan assets are pooled and managed by professionals like us, so participants don’t have to pick their own funds and manage their asset allocation.

The tradeoff: Owners must make up difference between the interest crediting rate and actual performance.

If the plan’s assets earn more than the crediting rate in a given year, the business owners have to reduce contributions the next year. Conversely, if the plan’s assets fail to deliver the interest crediting rate, the company must make up the difference with additional cash contributions.

For example, if your portfolio is supposed to return 5%, but it has a -10% negative return, the plan’s total balance would be 15% short. That means a $2 million plan would be down $300,000, and you’d have to make up the difference to prevent freezing or limiting benefit payments and paying much higher PBGC premiums.

In the event your portfolio returns 20% one year, outperforming its interest crediting rate of 5%, your balance could be $300,000 higher than projected. In that case, partners may have to lower their contributions, which wipes out the big tax deferral you were after.

The solution is for your plan advisor to invest in a conservative way to target that 5% return. And it’s important that you’re comfortable with your commitment and have the cash flow to support it. As an advisor, that’s something I pay special attention to. You’ve likely heard the phrase “house poor” to describe what happens when someone pays so much toward their mortgage that they’re feeling the squeeze everywhere else. I don’t want you to feel cash-balance poor.

3. You can take it with you.

Benefit:

Plan participants don’t have to worry if they change jobs. Like a 401(k)—and unlike old-school pension plans—you can take the balance from your plan and move it into an IRA.

The tradeoff: The assets are all invested in one account.

Everyone in a cash balance plan has the same crediting rate. That means if one participant is a super aggressive investor and another is conservative, they’re stuck with a single approach and both get the same return. But a cash balance plan is often something you have in addition to a 401(k) and other investment accounts, where you may have more discretion on investment decisions.

Taking advantage of a cash balance plan

Once you understand these tradeoffs, you can work within the rules to find the right approach for your company. What makes me excited about cash balance plans is the flexibility they offer. For example, you don’t have to save the max: You take it slow for the first couple of years with a smaller contribution, such as $50,000. Then, once you understand how the plan works, you can bump up the savings. This approach can help people avoid surprises that might affect the company’s cash flow.

And as I said above, if you choose to offer a cash balance plan you’re not limited to using only that account. You can also offer a 401(k) to manage the costs of contributions on behalf of your employees. A law firm, for example, could offer a 401(k) to everyone at the firm and then add a cash balance plan only for partners and administrative staff. That would avoid the cost of making large contributions for non-partner attorneys with high salaries.

A qualified plan advisor can take on the burden of sorting out those details. You want someone on your side who understands your goals and your business—both where you’ve been, and where you’re headed. That way, the advisor can look ahead for ways to improve the plan or spot potential problems. With a good partner in place, proactively advocating for you, a cash balance plan in addition to other types of retirement accounts can indeed be a way to accelerate retirement savings—without exposing you to potential mistakes that undercut their wealth-building potential.

If you would like to discuss how we could help your corporate retirement plan - schedule a meeting with me today.

MattBaisden-6016

 

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Speak to Matt: (314) 392-4630

 

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Disclaimer: This material has been prepared for informational purposes only and should not be used as investment, tax, legal or accounting advice. All investing involves risk. Past performance is no guarantee of future results. Diversification does not ensure a profit or guarantee against a loss. You should consult your own tax, legal and accounting advisors.

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With four years’ of portfolio management experience under his belt, Matt came to Plancorp in 2016 to join our Retirement Plan Advisors practice. He loves helping business owners build retirement plans that make their companies stronger and give owners the ability to retire when they want. More »