Significantly Increase Plan Contributions by Adopting a Cash Balance Plan

Monday, November 26, 2012

Recent legislative changes have created 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 defined benefit plan (DBP). 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 DBP, 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 DBPs 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, to the employees it looks like a DCP. 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 2012, the maximum contribution an employee can receive in a DCP is $50,000 (plus the $5,500 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 $150,000 range. By establishing a Cash-K plan, employers can substantially increase tax deferred contributions to business owners. Prime candidates for a Cash-K plan are highly profitable companies where the owners earn in excess of $250,000. 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.

One disadvantage of a traditional DBP plan is that the plan must be fully funded for all participants before the business owner is entitled to their full benefit. Thus DBPs 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. 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.

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. Please see the example below of a cash balance plan design.

In order to determine if a CBP can be right for your company, contact Administrative Retirement Services.

Name Age Pay 401(k)
and CB as
a % of
Plan Pay
Owner 56 250,000 22,500 7,500 25,675 183,750 239,425 79.18%
Employee 1 28 47,000 1,800 1,410 2,468 705 6,383 9.75%
Employee 2 29 67,000 3,275 2,010 3,518 1,005 9,808 9.75%
Employee 3 33 49,000 1,900 1,470 2,573 735 6,678 9.75%
Employee 4 50 88,000 0 2,640 4,620 1,320 8,580 9.75%
Employee 5 38 79,000 3,400 2,370 4,4148 1,185 11,103 9.75%
Employee 6 51 64,000 3,000 1,920 3,360 960 9,240 9.75%
Employee 7 51 191,000 0 5,730 10,028 2,865 18,623 9.75%
Total   835,000 35,875 25,050 56,388 192,525 309,838  
Employer Contributions to Employees 17,550 30,715 8,775 57,040  
Employer Contributions to Owner 7,500 25,675 183,750 216,925  
% of Contributions to Owner       79.18%