WHO ARE CASH BALANCE PLANS GOOD FOR?
They work well for successful businesses that:
- want to deduct more than $50,000 for each owner,
- have a reliable earnings stream, and
- can make a contribution for employees every year, usually 5% to 7½% of pay.
HOW DO CASH BALANCE PLANS WORK?
Each year, all plan members get cash balance credits (a.k.a. pay credits, as a % of pay) added to their account. They also get interest credits on the account balance. The interest credit rate is specified in the plan. That’s what makes this a defined benefit plan, with its big tax deduction opportunities.
HOW MUCH CAN WE CONTRIBUTE AND DEDUCT?
A lot of money. With the right demographics, annual tax deductions of $100,000 to $200,000 per owner are possible. They can be even higher in the first year.
HOW LONG SHOULD THE PLAN BE IN PLACE?
One of the IRS requirements for a qualified plan is “permanence”. The best practice is to keep it in place for at least five years. You can reach the maximum opportunity, a cash balance account value over $2 million, if the plan is in place for ten years.
MAY WE COMBINE A CASH BALANCE PLAN WITH OTHER RETIREMENT PLANS?
Yes. They work best when paired with a 401(k) and a profit sharing plan. The 401(k) plan gives flexibility for individuals, the profit sharing plan gives flexibility for the employer, and the cash balance plan gives a stable (and potentially large) annual contribution.
Maximum annual tax deductions can be much higher for cash balance and other DB plans (often $100,000 or more) than for DC plans (about $50,000). Since 2000, owners can have both deductions, e.g. $100,000 cash balance plus $50,000 401(k)/profit sharing.
WHO MUST BE INCLUDED?
A cash balance plan must cover the smaller of 50 employees, or 40% of the group.
For large law firms or medical groups, that could be just attorneys or physicians. That makes sense, because they’re each paying for their own benefits. To support the cash balance plan, the firm contributes to staff employees’ profit sharing accounts.
WHAT ARE THE MINIMUM BENEFIT LEVELS?
Enough people to meet the 50/40% rule above must get a “meaningful benefit”. For non-owners, the IRS considers this to be a benefit of at least ½% of pay at retirement for each year of service. That’s different from a ½% pay credit. Depending on participant age and cash balance interest rates, it might take a 2% or 3% pay credit to generate a ½% lifetime retirement benefit.
We’ve seen designs that don’t comply with this rule — even by those that claim to be cash balance design leaders. And we’ve seen designs that appear to fail, but pass once you look closer. There’s more to it than meets the eye. Be careful out there.
MUST ALL MEMBERS GET THE SAME CASH BALANCE PAY CREDITS?
No. The plan can be designed with different pay credits for different groups. The best practice is to set cash balance pay credits by existing criteria like age, service, practice area, or ownership percentage.
CAN WE REALLY MAKE SIGNIFICANTLY HIGHER CONTRIBUTIONS FOR OWNERS?
Yes, as long as the plan is properly designed. IRS regulations allow for some disparity, so that some employees can defer more of their compensation while others take more of it in cash.
A qualified plan must not discriminate in favor of highly compensated employees, but the IRS has a process called cross-testing that allows us to convert contributions to retirement benefits for nondiscrimination testing.
ARE CASH BALANCE PLANS “QUALIFIED PLANS?”
Yes, if they’re set up to follow all the IRS rules.
A qualified retirement plan has three main tax advantages:
- contributions are tax deductible for the firm,
- investment earnings build up tax free, and
- participants aren’t taxed until they receive the benefits.
Qualified plans have many other advantages, including:
- protection from bankruptcy and other creditors, and
- the option to “roll over” the money to an IRA or another qualified plan.
WHY NOT USE A NONQUALIFIED PLAN?
They really don’t work for employee owners like law firm or medical group partners, because the firm doesn’t get a tax deduction. That means the owners are taxed as if they had received the contributions in cash.
MAY WE VARY OUR CONTRIBUTION LEVEL?
Yes, within limits. You should pick a contribution level that you can sustain every year. We can design plans with huge deductions the first year and smaller after that.
The plan can be amended to raise or lower cash balance credits, but you don’t want to do that often. The IRS might consider a plan that’s amended frequently to really be a profit sharing plan, with much lower deduction limits. Even worse would be a plan with individual annual elections. The IRS might consider that to really be a 401(k) plan, with even lower deduction limits.
WHAT IF WE CAN’T MAKE THE CONTRIBUTIONS WE PLANNED ON?
You can amend, freeze or terminate the plan. If you can demonstrate business hardship, you may be able to terminate the plan even if it hasn’t been in place for five years.
HOW SHOULD CONTRIBUTIONS BE INVESTED?
Very conservatively, to match the cash balance interest crediting rate. Under current law, that’s usually a Treasury-based rate. If annual contributions equal pay credits (as most cash balance plan sponsors prefer), investing to match the interest credits keeps the plan from becoming underfunded.
If the plan becomes underfunded, a lot of bad stuff happens: benefit restrictions, required quarterly contributions, participant notices, etc. Partners who leave get 100 cents on the dollar, and that makes the underfunding worse for remaining partners.
If you want to take investment risk, do it elsewhere — like in the 401(k) or profit sharing plan. It’s usually not worth it in a cash balance plan.
HOW CAN WE GET A CASH BALANCE PLAN ILLUSTRATION?
For a free consultation, call us toll free at 888.596.5960 or email us at firstname.lastname@example.org. Let us know what you’d like to accomplish. Together, we can figure out what’s best for you. It might not be a cash balance plan; they’re certainly not for everyone.
WHAT FEES ARE INVOLVED IF WE MOVE AHEAD?
There are one-time fees for plan design and documents, and most attorneys would recommend getting IRS approval of the plan. Actuarial valuations, benefit statements, government filings and nondiscrimination testing are required every year. Cash balance plan fees are higher than for DC plans or traditional DB plans, because there’s more work involved. But if a cash balance plan is right for your firm, it’s well worth it.
HERE are some articles and speeches about cash balance plans. For current developments, see the cash balance plan section of our retirement plan blog.
Cash Balance & Hybrid Plans – Final & Proposed Regulations
Minneapolis Pension Council, October 2014
A Plan for Doctors and Professionals,
Market-Based Cash Balance Plans
Minneapolis Pension Council, December 2013
Cross-Tested Plans – How-to & Examples
ISCEBS Symposium, Boston, September 2013
“The New Pension Funding Regulations: They’re Not All They Appear to Be”
International Foundation of Employee Benefit Plans, webcast November 2009
Professional Firm Cash Balance Plans,
Van Iwaarden Associates, September 2009
Plan Gets Stamp of Approval,
Financial Advisor Magazine, May 2007
FAQ’s About Cash Balance Pension Plans,
US Dept of Labor
Cash Balance: Friend or Fraud?
Employee Benefits Planner, Second Quarter 1999