If you’re a business owner nearing retirement, but find your savings falling short, establishing a cash balance plan may help you catch up. 415 Group Partner David Talenda, CPA, explains the benefits and the risks of these plans:
“Cash balance plans are an option that not everyone is aware of, but not a week goes by where I don’t talk to someone who could potentially benefit from one. Many business owners can benefit from a cash balance plan. However, for older individuals who are closer to retirement age, these plans can be an especially effective vehicle for putting a lot of money away tax free — a larger amount than what’s permitted under a typical 401(k).
As a business owner, if you spent most of your career establishing your business and reinvesting money in it, you may not have been focused on saving money for your retirement. Because of the way these plans work, it might benefit you to create a cash balance plan which would allow you to start putting money away at an accelerated rate.
A cash balance plan is a defined benefit plan, but it’s structured more like a defined contribution plan, similar to a 401(k). The benefit to which you and your employees are entitled is shown like an account balance, even though it’s not technically allocated that way, so it’s easier for employees to understand. Employees earn compensation credits and interest credits every year which increase their hypothetical account balances.
There are some risks though. A 401(k) plan is often set it up as a discretionary contribution, so at any point in time you can amend what you put in. You’re not able to do that with a cash balance plan. Employers also bear the investment risk.
If you’re thinking about a cash balance plan, give 415 Group a call. There are many factors specific to every situation that will determine the viability of implementing such a plan. We’ll help you assess your situation and create a plan to help you meet your retirement goals.”
Business owners may not be able to set aside as much as they’d like in tax-advantaged retirement plans. Typically, they’re older and more highly compensated than their employees, but restrictions on contributions to 401(k) and profit-sharing plans can hamper retirement-planning efforts. One solution may be a cash balance plan.
Defined benefit plan with a twist
The two most popular qualified retirement plans — 401(k) and profit-sharing plans — are defined contribution plans. These plans specify the amount that goes into an employee’s retirement account today, typically a percentage of compensation or a specific dollar amount.
In contrast, a cash balance plan is a defined benefit plan, which specifies the amount a participant will receive in retirement. But unlike traditional defined benefit plans, such as pensions, cash balance plans express those benefits in the form of a 401(k)-style account balance, rather than a formula tied to years of service and salary history.
The plan allocates annual “pay credits” and “interest credits” to hypothetical employee accounts. This allows participants to earn benefits more uniformly over their careers, and provides a clearer picture of benefits than a traditional pension plan.
Greater savings for owners
A cash balance plan offers significant advantages for business owners — particularly those who are behind on their retirement saving and whose employees are younger and lower-paid. In 2017, the IRS limits employer contributions and employee deferrals to defined contribution plans to $54,000 ($60,000 for employees age 50 or older). And nondiscrimination rules, which prevent a plan from unfairly favoring highly compensated employees (HCEs), can reduce an owner’s contributions even further.
But cash balance plans aren’t bound by these limits. Instead, as defined benefit plans, they’re subject to a cap on annual benefit payouts in retirement (currently, $215,000), and the nondiscrimination rules require that only benefits for HCEs and non-HCEs be comparable.
Contributions may be as high as necessary to fund those benefits. Therefore, a company may make sizable contributions on behalf of owner/employees approaching retirement (often as much as three or four times defined contribution limits), and relatively smaller contributions on behalf of younger, lower-paid employees.
There are some potential risks. The most notable one is that, unlike with profit-sharing plans, you can’t reduce or suspend contributions during difficult years. So, before implementing a cash balance plan, it’s critical to ensure that your company’s cash flow will be steady enough to meet its funding obligations.
Right for you?
Although cash balance plans can be more expensive than defined contribution plans, they’re a great way to turbocharge your retirement savings. We can help you decide whether one might be right for you.