There is a long list of retirement plans available to plan sponsors who are looking for a strategy that will allow them to meet their personal financial goals while also helping their employees achieve theirs. From pension plans to 401(k)s, the list of options out there can be overwhelming. One of the options is a cash balance plan. What are they? How do they work? Are they the right option for you? Let’s talk.
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Think of cash balance plans as a traditional pension plan with a twist. Like a pension, cash balance plans are calculated based on a lifetime income at age 65 and funding the necessary amount to provide that benefit. Cash balance plans offer the potential for large savings for older business owners with high incomes, however, like a traditional 401(k), the benefit is stated as a balance in an account rather than as a monthly income stream like a pension. Also like a 401(k), these plans are transferable: and it is this change on traditional pensions which makes cash balance plans a bit easier to understand. On the other hand, unlike a 401(k), employees cannot make their own contributions to the plan since it is a defined benefit plan rather than a defined contribution.
How do Cash Balance Plans Work?
Participating employees are promised a certain sum of money upon their retirement, which they can take in one of two ways: first as regular monthly checks (like traditional pensions), or, second, as a lump sum upfront. Cash balance plans also allow employers to make greater contributions to retirement savings, which can make a big difference to employees who need to play “catch-up” in their retirement preparations. In addition, the contribution limits become less restrictive as the plan sponsor ages.
On the company level, setting up a cash balance plan can bring tax benefits along with it. This is because any contribution the employer makes into employee accounts are tax-deductible at the corporate level and the contribution is tax-deferred for the employee. On their end, participants get regular statements explaining the value of their retirement account. It should be noted, though, that this explanation is somewhat hypothetical because the money is technically the money is in a pension plan account which is a pool for all the other employees. In essence, that money is earmarked for individual employees; annually, this pooled fund is accounted for on an annual basis.
Is a Cash Balance Plan Right for You?
Well, cash balance plans are most popular among small businesses with older, higher-income owners who have some kind of tax problem while also needing increased retirement savings. Cash balance plans allow the owner to make a large contribution to themselves, make smaller contributions to employees, and defer taxes to a time when, hopefully, they are in a lower tax bracket. Because cash balance plans are a type of pension plan, the contributions are not discretionary—they are a promised benefit that must be made on an annual basis. For a highly profitable business, cash balance plans can be a great solution.
