Fund Retirement and Reward Workers with a Cash Balance Plan
Cash balance plans are defined benefit plans that share some key characteristics with 401(k) plans, which makes them flexible and appealing to a growing cadre of small employers. In fact, there was a 17% increase in new cash balance plans between 2017 and 2018.1
The Tax Cuts and Jobs Act helped boost the popularity of cash balance plans, because making deductible contributions can help partners in professional service firms and other business owners reduce their income below certain thresholds to qualify for an additional 20% tax cut.
These hybrid plans have generous contribution limits that increase with age. In 2021, a 65-year-old could save as much as $276,000 in a cash balance plan, while a 55-year-old could save $207,000 on a tax-deferred basis (until the account reaches a maximum accumulation of $2.5 million).2 They can also be stacked on top of a 401(k), which has a maximum contribution of $26,000 in 2021, or $64,500 with a profit-sharing plan.
Having the ability to make larger contributions may allow business owners to reduce their tax burdens, build retirement savings, and reward valuable employees — all at the same time.
Assuming the Risk
A cash balance plan is also a powerful tool for employee recruitment and retention. As with other defined benefit plans, employees are promised a specified retirement benefit, and the employer is responsible for funding the plan and selecting investments. However, each participant has an individual account with a “cash balance” for record-keeping purposes, and the vested account value is portable, which means it can be rolled over to another employer plan or to an IRA.
But unlike a 401(k), the participant’s cash balance when benefit payments begin can never be less than the sum of the contributions made to the participant’s account, even if plan investments result in negative earnings for a particular period. This means the employer bears all the financial risk.
Cash Balance Plans by Business Type
Source: 2020 National Cash Balance Research Report, Kravitz
Funding the Plan
Each year, the employer makes two contributions to the cash balance plan for each employee. The first is a pay credit, which is either a fixed amount or a percentage of annual compensation. The second contribution is a fixed or variable interest crediting rate (ICR). The ICR can be set to equal the actual rate of return of the portfolio, if certain requirements are met, which helps reduce the employer’s risk of having an underfunded plan.
Weighing the Costs
The amount that the employer must contribute to the plan each year is actuarially determined based on plan design and worker demographics. Businesses may take a tax deduction for contributions to employee accounts, so current-year tax savings may offset some of these costs. Still, a cash balance plan is typically more cost-effective if you are a sole proprietor or an owner of a firm with just a few employees.