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Understanding Cash Balance Plans

A cash balance plan can be a great way for business owners to accumulate tax-deferred retirement savings, but there are many key points to consider.
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A cash balance plan is a “hybrid” retirement plan with features of both a traditional defined benefit plan and a defined contribution plan. When you establish a cash balance plan, the employer promises participating employees a contribution credit and an interest credit to their “hypothetical account” each year. These are often referred to as hypothetical accounts because instead of reflecting actual contributions, they reflect a promised lump sum when the employee retires. The hypothetical account represents each participant’s retirement benefit.

The cash balance plan looks like a defined contribution plan with one exception—the interest credit. This is what makes it a defined benefit plan. Where a defined contribution plan credits an actual rate of investment return, the cash balance interest credit is guaranteed by the employer.

Why would a business owner establish a cash balance plan?

  • Older business owners can “catch up” on their retirement savings.
  • Larger tax-deductible contributions are allowed than in a defined contribution plan.
  • Plan design can favor owners and/or key employees.
  • Retention of quality employees.

While a cash balance plan can be a great way for business owners to accumulate tax-deferred retirement savings, there are many key points to consider before setting up the plan.

  • A cash balance plan is a defined benefit plan, so the contribution is required. Defined benefit plans generally must be in place for three to five years.
  • Contribution credits are determined based on a formula set in the plan document and can only be changed by amending the plan; however, the plan cannot be amended to change the formula each year. The maximum cash balance formula is based upon age and compensation and can vary by individual participant.
  • A cash balance is often paired with a defined contribution plan, like a 401(k) plan. When this occurs, the cash balance plan cannot typically pass the required nondiscrimination testing without including contributions made to the defined contribution plan. As a result, even though employer contributions to a defined contribution plan are discretionary, when paired with a cash balance plan, these contributions become required as well.
  • Changes in the demographics of the business can significantly impact the employee cost.
  • Plan assets are held in a pooled account directed by the plan trustee.
  • Unlike defined contribution plans, the rate of return on investments does not directly impact the value of a participant’s account. Cash balance plans are designed to target a specific benefit at retirement using a guaranteed interest credit, often 5%. If the rate of return on investments is more than the guaranteed interest credit, future required contributions may be reduced. If the rate of return is less than the guaranteed interest credit, future required contributions will be increased to make up for the shortfall.
  • Since the benefits in a cash balance plan are defined (the hypothetical account balance), a plan is overfunded if assets are greater than the total of all hypothetical account balances. A pre-funded balance is created when contributions exceed the minimum required amount. These additional contributions can be added to a pre-funded balance and can be used to satisfy minimum funding in future years, assuming the plan is at least 80% funded. Surplus assets are created by greater-than-expected investment returns. The minimum required contribution can be directly offset by the surpluses, assuming the assets exceed total liabilities. The existence of a surplus in a cash balance plan allows for funding flexibility in future years if company revenue decreases.
  • While a surplus results in funding flexibility, if the plan still has a surplus at termination, it may be subject to a 50% excise tax. If an overfunded plan has a maximum formula, contributions might have to be reduced or eliminated in the last few years before termination. If the plan does not have a maximum formula, the benefits can be increased to reduce the surplus. The excise tax is reduced if a portion of the surplus is transferred to a replacement plan. The excise tax can be eliminated, or deferred, if the entire surplus is transferred.
  • The plan can be amended to freeze or reduce the contribution credit. However, once the benefit is earned (typically after working 1,000 hours), it cannot be decreased for that plan year. The plan can always be amended for future years. If the minimum required contribution is not made, the plan sponsor owes a nondeductible 10% excise tax on the deficiency payable to the IRS.
  • If the plan’s funded percentage falls below certain levels, distributions to highly compensated employees may be impacted, and benefit restrictions may apply.
  • Cash balance plans are required to pay per-participant premiums, and file annually with the Pension Benefit Guaranty Corporation (PBGC). Plans established and maintained exclusively for substantial owners and plans of professional service employers that have 25 or fewer active participants are not covered by the PBGC. The current annual flat-rate premium, PBGC filing fee for 2023 is $96 per participant for a single employer plan. A variable rate also will apply to plans that are underfunded based upon PBGC funding rates.
  • If the plan includes non-owner participants, an ERISA fidelity bond for an amount equal to 10% of plan assets is required.
  • As with most qualified plans, the plan document must be restated every six years based upon a date predetermined by the IRS.
  • Amounts contributed during the plan year in excess of the tax-deductible amount calculated by the actuary will be subject to a 10% excise tax. No contributions can be made until the plan document has been signed.
  • These types of plans require a complex actuarial valuation each year and must remain in compliance with all IRS rules and regulations. For the cash balance plan to be successful, it’s essential that the plan sponsor, their advisors, and your actuary work together.

If you have any questions or need assistance, please reach out to a professional at Forvis Mazars.

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