A Beginner's Guide to Cash Balance Plans

A Beginner’s Guide to Cash Balance Plans

In my financial planning practice I work with a good number of business owners who want to make aggressive contributions to their tax deferred retirement accounts.  This helps put them on strong footing for retirement, but also provides a generous tax deduction.  While the 401k plan is the primary retirement plan most business owners are familiar with, a cash balance plans is one I often recommend in addition.  In fact, cash balance plans can actually allow for far greater contributions & tax advantages.

A cash balance plan could be a good fit if you’d like to contribute over $50,000 per year to a tax advantaged retirement plan.  They don’t come without their nuances though.  This guide will explain how cash balance plans work and whether they might be a good fit for you.


What Cash Balance Plans Are

Cash balance plans are a type of qualified retirement plan.  Basically, the IRS allows businesses to establish and fund different types of retirement plans that qualify for tax advantages and creditor protections.  401(k) plans are “qualified”, as are pensions, profit sharing, and cash balance plans.

Rather than a 401(k), cash balance plans are only funded with employer contributions.  When you establish a plan, you decide how much you want to contribute on behalf of each employee.  This is either a percentage of compensation or a flat dollar amount, and is specified in a plan document.  You also specify a crediting rate, which is the rate that each participant’s benefits grow each year.

When you & your employees depart from service, you’re eligible to receive the vested amount of benefits promised by the plan.  Most cash balance plan participants elect to roll their benefits into an IRA in order to defer taxation.  For this reason cash balance plans are often described as “hybrid” plans, since the benefits are defined (like a pension) but you can control the proceeds once you separate from service (like a 401k).


How Cash Balance Plans Work

Each participant in the plan has an account that is maintained by an actuary who sends statements, updates, and disclosures as needed.  Every year the actuary applies the crediting rate to benefits accumulated in prior years.  They then add this amount to the current years’ contributions to determine each participants’ accumulated benefits.


For Example:

Let’s say that you establish a cash balance plan this year.  You’re the only participant, and you choose a crediting rate of 5%.  You contribute $75,000 in year 1.  In year 2 you would have an accumulated benefit of $75,000 * 1.05% = $78,750.


Note here that this is NOT the amount you actually have in the plan’s account.  It’s the benefits that have accrued in the plan.  This point is important.  When you establish a cash balance plan, you’re promising your participants that the plan will provide the benefits and interest credit stated in the plan document.  If the funds in the plan’s account fall short of that, the sponsor (you) will need to make up the difference.


Annual Contributions

Every year, the actuary administering your plan will calculate your contribution to the plan.  It’s based on three factors:

  • Accumulated benefit
  • Annual interest credit
  • Investment performance

The accumulated benefit is the percentage of compensation or flat dollar amount that goes into the plan each year.  The annual interest credit is the amount that prior years’ benefits grow by.  The third factor is the wild card: investment performance.


For Example:

Continuing the example above, let’s say that you just established your cash balance plan with a 5% crediting rate, and made your first contribution of $75,000.  In year 2, the total benefits promised by the plan would be $78,750.

If your account balance at the end of first year is $78,750, you’re right on track.  If it’s greater than $78,750, you’re golden!  The extra investment performance means that you’ll need to contribute less than $75,000 in year 2.  But if the account balance is less than the total benefit the plan has promised, you’ll need to make up the difference in this year’s contribution.


Investment Strategy

Most participants in 401(k) plans prefer to invest their accounts for long term growth.  Even if you’re approaching retirement, you may want as much as 60% of your account in stocks in order to keep up with inflation over time.

Cash balance plans are a different animal.  Since you’re on the hook for the benefits, the investment objective in a cash balance plan should be a return that equals it’s crediting rate.  For this reason, most cash balance plans will set the crediting rate near the current yield on long term bonds.  This allows you to invest the account in a diversified bond portfolio that produces more consistent returns without tremendous risk.


Why You Might Want to Use a Cash Balance Plan

Cash balance plans are unique, and not for everyone.  Since you’re responsible for the benefits promised in a cash balance plan, it’s important that your company has a history of consistent profitability.  Like pension plans, economic turmoil can be a double whammy.  Not only does business suffer when the economy turns, but the balance of your plan’s investments might as well.  Making larger contributions because your account balance hasn’t kept up with the plan’s crediting rate can be challenging when business slows.

Additionally, it doesn’t usually make sense to establish a plan unless you’re committed to contributing at least $50,000 per year toward retirement.  There’s a fair amount of compliance and administration cost involved.  Plus, if you’re contributing less than $50,000 you’d be better off with a 401k, if you don’t have one already.

That said, the annual contributions for cash balance plans can be very high.  Like other defined benefit plans, the IRS limits the amount the account can grow to – not how much you put in every year.  Right now that amount is about $2.6 million.  Because of this, the most you can put in on an annual basis is based on your age.  If you’re establishing the plan at age 50 & set a retirement age of 65, you’ll only have 15 years to reach the $2.6 million limit.  Establishing a plan at age 40 gives you 25 years to reach the same $2.6 million limit, making your maximum annual contributions lower when you’re younger.

For this reason, cash balance plans are generally a great fit for owners of profitable businesses that want to catch up on their retirement savings by making aggressive contributions.  It can work in other circumstances, but that’s typically what I see.


Cash Balance Plan FAQs

Can I Combine Other Retirement Plans With a Cash Balance Plan?

Absolutely!  Most cash balance plans I’ve seen are combined with a 401(k) plan, as it allows for a larger annual retirement contribution.  It’s also a nice combination of a defined contribution plan (where you & other participants can contribute through salary deferrals if you want) and defined benefit plan (where your business will be compelled to make contributions whether you like it or not.


Can I Change My Contribution to a Cash Balance Plan?

You can change your contribution amount for a given year, but it requires an amendment to your plan document.  There are also rules against making amendments too frequently.  So while it is possible to make changes, if you’re not comfortable with a required annual contribution that’s out of your control, a cash balance plan may not be the best idea.


How Much Can I Contribute to a Cash Balance Plan?

This depends on how old you are.  Being a defined benefit plan, the IRS limits the total amount you can accrue in a cash balance plan (currently it’s about $2.6 million).  If you’re older you have fewer years until reaching retirement age.  Since you’d have fewer years to make contributions and hit this cap, your maximum annual contributions will be higher.  The younger you are, the lower your maximum annual contributions since you have more time to reach the cap.  The actual amount is determined by a formula in your plan document.


How Are My Funds Invested in a Cash Balance Plan?

Once you contribute to a cash balance plan, you’ll need to invest the funds in a manner consistent with sound fiduciary principles.  Remember – cash balance plans are “qualified” in the eyes of the IRS, meaning you need to operate them in the best interests of all participants.  Not just yourself.

Most sponsors of cash balance plans work with an advisor for help investing their contributions.  Generally, the idea is to build a portfolio with an average return that equals the plan’s crediting rate.  The mix of assets that gets you there with the least amount of risk is what you’re looking for.  Since your contributions will depend on the account’s performance, you don’t want to be too aggressive with your crediting rates.  For this reason most plans wind up with a diversified bond portfolio.

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