Cash Balance Plans are very popular Defined Benefit retirement plans.

What is a cash balance plan and how does it work?

If you’re a business owner, you have enough things to worry about. Payroll, marketing, customer service… it all takes a great deal of time.

Eventually, you’d probably like to retire someday. This presents yet another challenge. What you may not realize, however, is that there’s a little-known type of retirement account that allows you tremendous tax deductions and aims for reasonable growth over time.

That plan is what we refer to as a cash balance plan. A cash balance plan is a type of defined benefit plan.

What is a cash balance plan?

A cash balance plan is a defined benefit plan sponsored by the employer. The plan promises to provide a monthly benefit to participants. The benefit is either a percentage of compensation or a stated dollar amount at retirement age (which is stated in the plan document).

The only difference between a cash balance plan and a defined benefit plan is how it’s presented. A traditional defined benefit plan shows monthly benefits, and the costs associated to provide the benefit. A cash balance plan illustrates the hypothetical contributions and interest credits that are allocated to an account. Those include the beginning balance, contributions, interest, and ending balance.

Both plans have minimum funding requirements, and a traditional defined benefit plan can actually convert into a cash balance plan. The cash balance plan becomes even stronger when combined with a 401k and/or profit sharing plan.

What types of companies can benefit from a cash balance plan?

Prime candidates for a cash balance plan are generally smaller professionals and groups such as:

  • law firms
  • medical practices
  • engineering and architecture firms
  • physicians
  • dentists
  • chiropractors
  • osteopaths
  • optometrists
  • lawyers
  • accountants
  • psychologists

The key is they should have consistent and positive cash flow and be run by highly compensated employees (HCE) in their peak earning years. Roughly a 5-1 ratio of non-highly compensated employees to one HCE makes the most sense.

This 5-1 ratio gives discrimination testing a better chance at passing. The more NON-HCE’s which are 10-15 years YOUNGER than the HCE’s the better, but in the range of 30% to 50% can work to pass non-discrimination testing.

What is a 412i plan?

A 412i is a Defined Benefit plan funded with life insurance products (such as whole life or universal life), or annuity investments. The 412i has:

  • No actuarial valuation report requirement to determine the minimum funding requirements,
  • No variable premium owed to the PBGC, and
  • The theoretical value of the product is the amount distributed to participants.

The problem with 412i plans is they’re highly scrutinized by the IRS. Many of them have been designed with contributions of excessive amounts which exceed minimum incidental death benefit rules and the 415 maximum benefit rules. Excessive insurance investments could cause the plan to be overfunded if a key participant dies.

When does a cash balance plan need to be set up?

The plan document must be signed before the end of the business’s tax year, and this typically takes a few weeks to a month.

What should cash balance plans invest in?

All investments in the cash balance or defined benefit plan are decided on/managed by the employer an/or their investment advisor. Because of this, the employer bears the financial risk.

This is different from the profit sharing and 401(k) side of the plan. In the profit sharing or 401(k) side, the employee bears the investment risk. To lower the employer’s financial risk, most contributions are made to that side of a combination cash balance/profit sharing/401(k) plan first.

If cash balance or defined benefit plan investments perform poorly, the owner must make up the difference with additional contributions. This is because the plan made the promise to pay the employee a specific amount per month upon retirement.

The plan sponsor (or business owner) and their investment advisor determine what these plans invest in. Plan assets are generally invested with a more conservative rate of return objective. This may include annuity contracts, mutual funds, or other investments.

To remain properly funded, a defined benefit or cash balance plan will generally need a return of 5% to 8% per year. The rate isn’t listed anywhere, rather it is actuarially determined based on the plan participants ages. The Plans actuary has limited discretion on the return required. In today’s lower rate environments, some plans use a target of 4% to 6% per year.

Investments in the plan must be traded on the open market generally speaking because non-liquid investments don’t always have a fair market value. A fair market value must always be available for determining the plans funding requirements.

What happens if my plan account doesn’t earn enough?

There’s a stated interest credit rate in the plan document which is specified by the plan sponsor. If the plan earns less than that amount, the shortfall is amortized over the next 7 years, and contributions must be increased by the sponsor to make up that shortfall.

For example, if the contribution is $100,000 and the interest credit rate is 5%, the plan must have $105,000 at the end of the first year. If it only has $98,000, the $7,000 shortfall must be contributed over the next 7 years at a rate of $1,000 per year.

There are other options to this amortization period which would be analyzed when the actuarial valuation report is prepared. If the Cash Balance plan investments earn more than expected, future year contributions may be reduced accordingly.

Do you have to cover all participants in a cash balance plan?

No, but you must cover the lesser of 40% or 50 employees with the cash balance plan, or in any defined benefit plan. Typical plan design covers all of the eligible employees with some sort of benefit – even if it’s the minimum amount allowed by law – because it’s easier to explain to employees.

You can reduce the number of eligible employees by separating classes of employees, for example, nurses, owners, staff, etc. This becomes a very “sticky” issue among the employee base, however, and may cause problems with employee retention.

Participants must be at least 21, have one year of service with at least 1,000 hours per year worked.

What is the maximum annual contribution to a cash balance plan?

This is calculated by a Third Party Administrator (TPA) and based on the participants’ annual benefit limit at their retirement age. The maximum annual benefit limit is $210,000 for 2016. This translates into a monthly benefit of $17,500 at the normal retirement age for the rest of the retirees’ life.

*UPDATE: The maximum annual benefit limit is $215,000 for 2017.

Contributions are adjusted to reflect current plan values versus where the plan assets should be to achieve the annual benefit for participants.

The maximum contribution to the business owner is based on the owner’s age. It generally looks something like this:

Cash Balance Plans allow large pre-tax contributions.

Cash Balance Plans allow the business owner to stash a lot of money away pre-tax.

Different groups of employees can elect different percentages of pay. The amount can’t be changed year to year, however.

Hypothetical contributions can’t be changed unless the formulas to determine these hypothetical contributions is related to a percentage of the employees’ compensation. In that case, the hypothetical contribution can rise or fall based on the compensation of the employee.

Bonuses typically count towards the calculation of retirement plan benefits. Alternatively, consider reducing bonus amounts and increasing retirement benefits for employees. Bonuses increase payroll taxes whereas retirement plan benefits paid by the business are not subject to payroll taxes.

Am I required to contribute every year?

A big concern for business owners is what happens if a partner gets sick? What if their income drops?

In this case, the plan could be amended provided they haven’t been credited with a year of accrual service during the plan year, and the design has different rate groups for participants. This could reduce the amount of required contribution for that partner.

Generally, you’re locked into making defined benefit or cash balance plan contributions. However, you could possibly reduce the amount of contributions by taking steps to freeze benefit accruals.

To freeze accrual benefits, you’d need to complete all necessary steps to freeze the plan before the participants accrue benefits for the plan year. Notices must be given prior to freezing the plan (the timeliness of these notices is based on the number of participants in the plan).

When are cash balance plan contributions due?

Contributions are due by the tax return due date plus extensions, but no later than 8.5 months after the plan year end. You can fund the plan prior to year-end, but be careful not to overfund the plan as this will create non-deductible contributions.

How do distributions from a cash balance plan work?

The normal retirement age is the later of age 62 or after 5 years of plan participation. Outside of retirement, plan funds aren’t generally accessible.

The 401(k) and profit sharing side of the plan may provide loan, hardship, and in-service withdrawals. The defined benefit/cash balance side of the plan would require a distributable event to occur to remove funds from the account. The following are distributable events:

  • Termination of employment,
  • Disability,
  • Death, and
  • Plan termination

If the plan document provides, a defined benefit or cash balance plan may provide loans as well for in-service distributions (at age 62)

Cash balance plan typically has a 3-year cliff vesting schedule. If employees leave prior to that timeframe they don’t take their balances with them. New plans can also exclude all past service, effectively setting everyone to 0% vested.

Can I terminate a cash balance plan?

To establish any qualified plan, an employer must intend for the plan to be permanent. There isn’t any set time limit for how long the plan must stay in place, but the IRS may challenge its closure.

The IRS is unlikely to challenge a plans permanency if a qualified plan has been in existence for more than 10 years. Legitimate business issues for terminating a DB plan may be reasons such as:

  • a change in the ownership of the employer,
  • the liquidation or dissolution of the employer,
  • poor business conditions, or
  • the adoption of a new plan

What if the cash balance plan is shut down?

Plan assets may be:

  • Rolled over into an IRA, or
  • Participants can request the plan sponsor purchase an annuity contract, or
  • Participants can request their benefit in cash

Cash balance plans summarized

If you’re a small business owner, cash balance plans and defined benefit plans may provide an amazing opportunity to save for retirement. Contributions are deductible under IRS code 404 and should grow at reasonable rates of return over time provided they’re invested properly.