One of the most valuable pieces of an executive compensation plan, particularly for a small business owner or professional practice, is a cash balance plan. It allows the executive to benefit as both employer and employee and has retention benefits for a practice with both highly compensated employees who are getting close to retirement, and younger employees. Even if you already set up a 401(k) plan, adding a cash balance plan can make sense.
Breaking Down the Basics
On the employee side, a cash balance plan (CBP) is a traditional defined benefit pension plan offering either a lump sum payout or an annuity on retirement. However, it has an individual account structure, similar to a 401(k), that is portable and transparent. Unlike a 401(k), CPBs are not dependent on market performance, and employees do not need to select and manage the assets.
As an employer, you set an annual contribution as a percentage of salary, usually between 3-8%. This is comparable to the match for a 401(k) plan. If you choose to offer both, you can simply opt out of matching the 401(k) contributions. The employer also pays a set interest amount, which can be either a fixed or variable rate.
In certain situations, a CBP can be an effective tool to help highly-compensated employees save large amounts towards retirement. The annual limit for a 401(k) plan in 2021 is $58,000 ($63,500 for age 50 and older) while the maximum contribution for a Cash Balance Plan can be as high as $343,000. And that means the tax savings are higher, too.
Let’s look at some numbers:
A 60-year-old doctor wants to retire from her practice in five years. At that age, the upper limit for a CBP contribution is $276,000. Added to the $63,500 401(k) contribution, the annual total retirement contribution is $339,500. At a 37% tax rate, that’s a tax saving of $125,615.
If she hits 65 and wants to keep going? No problem – the lifetime limit is $3.0 million.
Employees don’t need to save out of their salary, and they don’t have to worry about the impact of markets on their savings. The employer makes the CBP contribution and the plan balance grows every year. The plans are also eligible for insurance provided by the Pension Benefit Guaranty Corporation, which covers firm risk.
CBPs can be structured so benefit levels can be matched to company and employee needs, as long as annual non-discrimination requirements are met. For example, a flat dollar contribution could be made to owners while other eligible employees receive a percentage of compensation.
What Should Employers Know?
Cash balance plans require the employer to fund the plan with cash. Your business should consistently produce a high enough level of revenue to cover the contributions. An actuary must certify every year that the plan is properly funded – which can raise administrative costs.
- How does the investment performance factor in?
Each participant has a hypothetical account that is credited with annual interest and contributions. In reality, the plan assets can be invested according to an asset allocation the employer determines. On an annual basis, if the underlying investments outperform the annual interest, the surplus accrues to the employer and can be used to reduce future funding contributions. The downside of this is, of course, if the investments underperform the employer must make up the difference.
- Greater flexibility
CBPs are defined benefit plans, and therefore have more flexibility in the formula for determining contributions. Contributions may be age- or service-related, different components of pay can be credited differently, and contributions can also be based on company performance.
The Bottom Line
Even if you have an existing 401(k), adding a Cash Balance Plan can help you create a flexible solution that can provide tax benefits and accelerate retirement savings for owners and partners. There are of course many more administrative and regulatory details that must be thought through, but if you’d like to know more about how a CBP can work for your business, we’re happy to have a conversation.