You’ve probably heard the fable of the ant and the grasshopper. But if you don’t remember, the short version is the ants planned ahead. The grasshopper did not, and paid dearly for it.
Suppose you’re the grasshopper.
You’re a business owner or partner with retirement savings that are totally inadequate for your anticipated requirements. You need a tax-advantaged and creditor-protected retirement plan that lets you build substantial assets in a short period of time. So, what can you do?
The answer to that question just may be an employer-sponsored cash balance plan. A well designed plan can potentially allow you to contribute nearly $300,000 per year, depending on your age and other factors.
A cash balance plan is a form of retirement plan that enables a business’ owners or partners and, optionally, key executives to build huge retirement assets in a short period of time. It is an employer-sponsored plan that can be created by any form of business entity, including for-profit and not-for-profit corporations, LLCs, partnerships and sole proprietorships.
The cash balance plan is a defined benefit plan and, as such, is subject to many of the same rules that govern other types of defined benefit plans, including minimum participation and nondiscrimination rules that generally require contributions for other employees. However, if the business also offers a profit-sharing plan the two plans can be tested together, lessening the impact of the rules on the cash balance plan.
How it Works
Once created, the plan establishes a separate hypothetical account for each participant, with the benefit at retirement based on the balance in that account. If you participate in such a plan, it can work alongside your 401(k) plan and/or IRA.
As a participant in a cash balance plan, your hypothetical account balance grows annually based on a pay credit (a flat amount or a percentage of compensation), plus a predetermined interest credit (a fixed rate or a variable rate pegged to an index).
This means that, unlike 401(k) plans and IRAs, your account balance does not reflect actual gains and losses on the plan’s underlying investments. It’s the reason the account is referred to as a hypothetical one. It also means that the business bears the risk if the plan’s investments grow at a slower rate than anticipated, or even lose value.
The maximum contribution amount each year is based on a formula established when the plan is created, and subject to certain legal limitations. Employer contributions are determined annually by actuaries and vary, like other defined benefit plan contributions, based on the age and compensation of plan participants, as well as the investment performance of plan assets.
The benefits in your account must vest within a three-year period. They grow tax-free and are taxed upon withdrawal.
Upon retirement, you receive a lifetime annuity based on the account balance, although some plans offer the choice of a lump-sum distribution. These lump-sum distributions can be rolled over tax free into IRAs or other retirement plans that accept rollovers.
Under certain situations, you can receive the lump-sum distribution or lifetime annuity before retirement — including disability, death, or the termination of your employment.
Financial and Tax Benefits
The primary benefit of a cash balance plan is its ability to build very large retirement accounts quickly — especially for business owners or partners who have, for many years, invested money in their businesses rather than their retirement accounts.
Participants have no risk related to a loss of value in the underlying investments. The business bears this risk.
Contributions to cash benefit plans qualify for a federal income tax deduction. In other words, contributions are made in pre-tax dollars. The business can deduct contributions for employees who are not owners or partners — and if it’s a corporation, it can also deduct contributions for owners. For a sole proprietorship or a pass-through entity (like a partnership) with income that is taxed on the individual tax return, contributions reduce taxable income, while they grow tax-free in the plan.
The participant’s vested benefit is portable and can be converted to a lump sum for rollover in the event of a change in employer.
Most, but not all, plans are insured by the federal Pension Benefit Guaranty Corporation (PBGC). For example, smaller professional service firms are excluded.
Cash balance plans must satisfy all IRS rules and regulations for defined benefit plans.
Plan assets are pooled for investment purposes. Participants cannot control how the balances in their individual accounts are invested.
Plans insured by the federal PBGC are required to pay annual premiums.
Cash balance plans are somewhat more complicated than 401(k) plans, so the administrative costs can be higher than defined contribution plans. They are, however, often less expensive than other defined benefit plans.
As with other defined-benefit plans, cash balance accounts have the potential to require large contributions at a time when the business isn’t able to afford them.
Where Cash Balance Plans Work Especially Well
In spite of the potential downsides, under the right circumstances, cash balance plans can enable business owners, partners and key employees to dramatically increase their retirement savings at a reasonable cost to the business.
A business considering a cash balance plan should have a stable or growing income stream. These plans do not work as well for businesses that are subject to large cyclical swings in revenue.
Cash balance plans work well in situations where the business is committed to providing retirement savings opportunities for all employees. This typically means there are other plans to assist in satisfying IRS nondiscrimination testing requirements. It also means that the business is willing to bear certain costs, actuarial and other, required to support the plan.
Cash balance plans are more often successful in businesses with a small number of relatively older owners, partners and key employees — or a high ratio of owners or partners to employees.
The owners, partners and key employees of the business must earn sufficient income to be able to defer substantial dollar amounts to the plan. Professional service providers are a typical example.
For more detailed information on cash balance plans, or to discuss how creating such a plan might impact your business or your retirement savings, give us a call.
We have experts on hand who can help with your cash balance plan.