A cash balance plan (CBP) is a type of defined benefit plan that allows business owners that have employees the ability to design a retirement plan that provides the majority of benefits to the business owner. The plan type works best if the business owners are the oldest employees in the company. A CBP provides more flexibility than a traditional defined benefit plan (DBP).
A CBP is a hybrid plan. While being a DBP, it looks like a profit sharing plan to employees. In a CBP, a hypothetical account balance is created for each participant. Contribution allocations and interest credits are provided to each hypothetical account (regardless of the plan’s actual investment experience). As in a DBP, the employer assumes the risk of investment gain or loss. There are also minimum annual funding requirements. This is a great plan for successful companies that want to reduce taxes and provide an excellent retirement plan benefit to the owners and employees.
A cash balance and 401(k) combo plans (Cash-K) can provide significantly greater tax-deferred contributions than just a 401(k) Plan. The Cash-K plan can provide these higher contributions because the limits for a CBP are generally higher than for a 401(k) Plan. In 2014, the maximum contribution an employee can receive in a 401(k) Plan is $53,000 (plus the $6,000 catch-up contribution if a participant has attained the age of 50), whereas in a Cash-K plan, the hypothetical contribution for a 56 year old could be $241,850.
This example is for a firm with an owner and seven employees.
|Name||Age||Pay||401(k)||Employer Safe Harbor||Employer Profit Sharing||Employer Cash Balance||Total||SH, PS and CB as a % of Participant's Pay|
|Employer Contributions to Employees||17,550||23,400||8,775||63,100|
|Employer Contributions to Owner||7,950||27,050||182,850||241,850|
|% of Employer Contributions to Owner||79.30%|
Current legislation allow significant opportunities for employers to generate additional tax deferred savings by sponsoring both a defined contribution plan (DCP) (such as a 401(k) plan) and a cash balance plan (CBP). For most business owners, this is the best tax-deferred savings opportunity that exists.
In a DCP, separate accounts are established for each participant. Both employees and employers may make contributions to the plan. Participants assume the risk of investment gain or loss.
In a CBP, participant benefits are determined based upon formulas specified in the plan. The employer makes all contributions to the plan. The contributions are calculated annually based upon actuarial methods and assumptions. The employer assumes the risk of investment gain or loss. Due to differences in the way benefits accrue and the way that actuarial funding methods spread the costs, traditional defined benefit plans (DBP) sometimes end up with significant funding shortfalls (i.e. the plan’s assets aren’t large enough to satisfy its liabilities).
A cash balance plan (CBP) is a hybrid plan that, while being a DBP, looks like a DCP to the employees. In a CBP, a hypothetical account balance is created for each participant. Contribution allocations and interest credits are provided to each hypothetical account (regardless of the plan’s actual investment experience). As a DBP, the employer assumes the risk of investment gain or loss. There are also minimum annual funding requirements.
The CBP document has a set formula which determines how the hypothetical contributions and investment credits are calculated. The formulas are typically based on a percentage of pay and different percentages can be specified for various employee classifications.
CBPs have been in existence since the mid-1980s. However, during the 1990s and early 2000s, there was a lot of bad press surrounding CBPs. Some large companies had converted their traditional DBPs into CBPs, resulting in legal action taken by the employees. (Note that these court cases were not about the CBP itself, but about the way in which the traditional DBP was converted.) Unfortunately, different courts came to different conclusions and as a result, there was a lot of uncertainty surrounding CBPs.
In 2006, Congress passed the Pension Protection Act (PPA), which cleared up a lot of the confusion and inconsistent law provisions surrounding CBPs. PPA also significantly increased the amounts that an employer can contribute (and deduct) to a DBP or CBP. A favored plan design incorporating CBPs is to set up both a CBP and 401(k) plan. We will refer to this arrangement as a Cash-K plan. This two-plan approach uses a combination of 401(k), safe harbor, profit sharing and cash balance contributions to maximize benefits to the business owner. Benefits and contributions under both plans are aggregated for purposes of satisfying the IRS’ discrimination tests.
A Cash-K plan can provide significantly greater tax-deferred contributions than a DCP alone. The Cash-K plan can provide these higher contributions because the limits for a DBP are generally higher than for a DCP. For example, in 2014, the maximum contribution an employee can receive in a DCP is $52,000 (plus the $6,000 catch-up contribution if the plan has a 401(k) feature and the participant has attained the age of 50). In a CBP, the hypothetical contribution for a 55 year old can potentially be in the $180,000 range. By establishing a Cash-K plan, employers can substantially increase tax-deferred contributions to business owners and a 55 year old business owner can receive around $221,000.
Prime candidates for a Cash-K plan are highly profitable companies where the owners earn in excess of $265,000. CBPs can be used by family businesses as part of their succession plans. Closely-held businesses, law firms, medical practices, and professional firms can all benefit from a CBP. For most business owners, this is the best tax-deferred savings opportunity that exists.
The caveat is that the employer must be somewhat generous to the rank and file employees. In a typical Cash-K plan, the employer will contribute 10% - 15% of compensation to all employees, with significantly higher percentages going to a specific group of employees such as the owners. The success of this plan design is greatest for a company with a relatively young workforce and owners who are older than the average employee.
An advantage of a CBP is that the likelihood of the plan becoming underfunded is significantly decreased, compared to a traditional DBP. The CBP allows the employer contributions to more closely match the benefits accrued each year. The CBP will specify a rate of investment return that is applied to the hypothetical accounts (say 5.5%). Note that additional contributions may be required if the plan’s investments earn less than the specified rate of return. Conversely, contributions are reduced when the plan’s investments earn more than the specified rate.
One disadvantage of a traditional CBP plan is that the plan must be 110% funded for all participants before the business owner is entitled to receive any benefits. Thus CBPs can have undesired consequences for businesses that experience a downturn due to events outside the control of the business owner such as change in technology, loss of a major client or offshore competition.
Like a DBP, one disadvantage of a CBP is that it can be costly and complex to administer. The plans are individually designed plans and have somewhat limited funding flexibility. Though the plan administrative and set up fees are more than a DCP, they can be well worth the cost due to the increased tax-deferred contribution amounts.
In order to determine if a CBP can be right for your company, contact Administrative Retirement Services.
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To determine if a CBP can be right for your company, or to setup this plan for your organization, please complete our Online Questionnaire.
You may also complete the questionnaire offline by downloading the form here and then faxing the completed form to our office.