One of the hurdles that business owners face when exploring a cash balance plan is deciding whether the cost of the plan justifies the cash balance deduction opportunities. It is a bit of a balancing act, but this post will review one such cost: the IRS “gateway contribution” for cross-tested cash balance plans.
The IRS allows cash balance plans to have some acceptable disparity between benefits provided to owners versus those provided to non-highly compensated employees. Most small-firm cash balance plans utilize these rules through a process call “cross-testing”. The cross-testing mechanisms are VERY complex and we won’t delve into the intricacies here, but the basic theory is:
- Large benefits are provided to owners through the cash balance plan.
- A reasonable benefit is provided to non-highly compensated employees through an annual profit sharing plan allocation.
- In order for the cash balance plan to pass the IRS non-discrimination testing rules, the cash balance benefits are combined with the profit sharing benefits and a single IRS nondiscrimination test is performed.
- IRS rules mandate that if a cash balance plan is cross-tested, then the total annual allocation for each non-highly compensated employee must be at least 7.50% of pay. This 7.5% minimum benefit is the “gateway contribution”.
So, many potential plan sponsors will learn during the plan design process that they have to provide their employees with retirement benefits equal to 7.50% of pay each year. If you are already giving employees a 5% profit sharing contribution each year, then it may be palatable to give them another 2.5% either in the profit sharing plan or in the cash balance plan. This could allow each of the owners to have an annual cash balance accrual of $100,000 or more.
However, if you have a large employee base (relative to the number of owners) or do not already provide generous retirement benefits to your employees, then you may find the cash balance gateway requirement of 7.5%-of-pay to be cost-prohibitive. This is one of the warning flags we talked about in our previous Eyes Wide Open post. You can read more more information on the nuts and bolts of cash balance plans at our informational website.
