By: Bryan Uecker

Over the last half-century, employers shifted most of the retirement plans away from employer-funded pension plans (defined benefit) to employee/employer-funded savings plans such as the 401(k) (defined contribution). Defined contribution plans continue to eclipse defined benefit plans by an ever-widening margin when considering the number of plans and total assets. However, one defined benefit plan is getting some recent attention: the Cash Balance Plan. Here are three reasons why:

1: Business owners can accumulate more for retirement and reduce current taxes.

The biggest attraction of a cash balance plan is that key employees can typically contribute more – often much more – to the plan. Look at the following table. A 60-year-old owner or key employee could contribute up to $30,000 in 401(k), or up to $73,500 if the 401(k) has a profit-sharing component. Adding the cash balance to the 401(k)-profit sharing plan would allow total employee and employer contributions of up to $375,500.

Moreover, employer contributions are deductible for the business.  This means an employer could have saved over $155,000 in taxes on that same 60-year-old.

2023 contribution limits.  401(k) limit includes annual catch-up contributions for participants aged 50 or older.  For illustrative purposes only.  Actual results may vary depending on the plan design, participant compensation, employee demographics, and projected retirement age. 

*Based on assumed combined federal and state tax rate of 45%.  Calculation uses “Total Annual Contribution” excluding 401(k) contributions.

2: Easy to understand and portable.

A cash balance plan is a defined benefit plan in which an employer credits a participant’s account with a “pay credit” (a percentage of pay or a flat dollar amount) and an “interest credit” (either a fixed or a variable rate).  The lumpsum benefit at retirement equals the “account balance” which is the accumulation of all annual pay and interest credits.  To the participant, it looks and feels like an interest-bearing savings account with annual deposits and earnings.

In a traditional defined benefit plan, the “goal” or the “what” that’s being defined is a monthly pension amount payable for life at retirement age.  The annual funding needed is based on whatever amount it takes to accumulate enough to pay out the promised benefits on the promised retirement dates. It’s not rocket science, but it takes an actuary to determine the present value of all future benefits and compare it with the plan’s current assets.  The actuary must make assumptions about current and future interest rates, mortality, turnover, inflation, salary increases, etc.

In a cash balance plan, the present value of benefits is in the ballpark of the sum of the “account balances”. The annual contribution is in the ballpark of the sum of the “pay credits” for the year.  The actuary keeps a tally of how the plan assets fare in reality compared to the “interest credit” for the year and adds plus or minus to the mix.

The cash balance plan is portable. Most defined benefit plans have a default payment of an annuity for life, the default payout for most cash balance plans is a lump sum that can be rolled into an IRA.

3: Allows for multiple employee groups with different contribution rates.

A cash balance plan works beautifully with a “new-comparability” or “cross-tested” profit sharing plan. Because a cash balance plan can be combined with a profit sharing plan for non-discrimination testing, employers with a cross-tested profit sharing typically requiring an allocation of 5% of compensation to non-highly-compensated employees in order to max-out contributions to key employees, can supercharge the amounts to key employees while sometimes only raising contribution requirements to non-highly-compensated employees by 2.5%.

2023 contribution limits.  401(k) limit includes annual catch-up contributions for participants aged 50 or older.  For illustrative purposes only.  Actual results may vary depending on the plan design, participant compensation, employee demographics, and projected retirement age. 

Please note that for certain plans that are not covered by the PBGC (e.g., owner-only/spouse plans and certain professional services businesses, etc.), employer contribution amounts to a 401(k)/profit sharing plan may be limited to an IRS deduction limit of 6% of total eligible compensation.

In the above scenario, the non-highly compensated employees can defer up to the maximum 401(k) contribution of $22,500. They all receive employer contributions totaling 7.5% of compensation made up of a 3% non-elective safe harbor, a 2% profit sharing, and a 2.5% cash balance. The owner can defer $30,000 in 401(k), including a $7,500 catch-up.  In addition, he can receive an employer contribution equal to 100% of compensation made up of a 3% non-elective safe harbor, ~10% profit sharing, and ~87% cash balance.

Frequent questions about cash balance plans.

Aren’t fees to administer cash balance plans expensive? The annual 5500 requires an attachment called Schedule SB which reports the funding adequacy of the defined benefit plan.  An enrolled actuary must certify the figures and assumptions on the form.  The need for an actuary adds a cost for cash balance plans that isn’t needed for most defined contribution plans. However, because the cash balance plan is usually valued once a year by the actuary and TPA (Third Party Administrator), and the assets are pooled, there is no need for a third-party recordkeeper, and the investment fees are typically lower than 401(k) plans.

Are annual contributions to a cash balance plan mandatory? Except for safe harbor plans, contributions to a defined contribution plan are usually discretionary meaning if the employer chooses not to contribute every year they don’t have to. For the cash balance plan, the actuary will calculate a minimum and maximum funding range every year and the employer must meet at least the minimum funding requirement.

What is the deadline to set up a new cash balance plan? Before 2020, a new cash balance plan had to be adopted by the last day of the plan’s first year. Thanks to the SECURE Act,  business owners can adopt a cash balance plan until the entity’s tax filing deadline (including extensions) for the plan’s first year. Because of the time needed to prepare the plan document, calculate the required contribution, and fund the contributions to the trust by the deadline, however, plan on a couple of months lead time.

Can a cash balance plan use a vesting schedule? Yes.  Most plans use a “three-year cliff” vesting schedule. 0% vested for years one and two and 100% vested with three years of service.

Why DRDA?  DRDA has spent decades developing real world solutions to everyday business issues.  As technology, resources and awareness change, our solutions are updated, introduced or replaced to make certain we offer the best solution today.  DRDA takes a holistic view of the business owners’ situation including a comprehensive financial and tax strategy – encompassing both personal and business. We offer integrated solutions that save time and money such as bookkeeping, payroll, and retirement plans.  This is all in service of creating better futures for our clients.  Where do you want to go from here?  Let us help you get there.

For an illustration call (281) 488-2022 or email bryan.uecker@drdacpa.com.