Cash balance plans: what to know before recommending one

For a profitable business whose owners want to put away more than a 401(k) allows, a cash balance plan is usually the next conversation. It can support deductible contributions several times the defined contribution limit, particularly for owners in their late forties and older. It also carries obligations that a 401(k) does not, and those should be understood before the plan is adopted rather than after the first difficult year.

How the design works

A cash balance plan is a defined benefit plan that presents itself to participants like a defined contribution plan. Each participant has a hypothetical account that grows in two ways:

• Pay credits: an annual credit, usually a percentage of pay or a flat dollar amount, which can differ by employee group within the limits of nondiscrimination testing
• Interest credits: a rate set in the plan document, which under the Pension Protection Act may not exceed a market rate of return

The accounts are notional. The plan's assets are held in one trust and invested together, and the employer bears the investment risk. The interest crediting rate can be a fixed rate (up to about 6 percent is treated as a market rate), a Treasury-based rate or the actual return on plan assets with a floor that protects principal. The choice drives the plan's funding behavior more than any other design decision.

Why owners choose it

Defined benefit limits are expressed as a benefit at retirement, not an annual contribution. For an older owner, the annual contribution needed to fund that benefit can be several times the defined contribution limit, and the pay credit can be set accordingly. Paired with a 401(k) with profit sharing, the combination lets owners defer substantially more each year on a pre-tax basis.

Since the SECURE Act, a plan can be adopted as late as the business's tax filing deadline, including extensions, and treated as adopted for the prior year. That makes genuine year-end planning with the CPA possible: the deduction can be sized after the year's results are known.

The testing that shapes the design

A cash balance plan is almost always tested together with the 401(k) and profit sharing plan under the nondiscrimination rules of Section 401(a)(4), usually on a cross-tested basis that converts contributions to projected benefits at retirement. Three constraints shape what is possible:

• The gateway. Before cross-testing is allowed, non-highly compensated employees must generally receive a minimum allocation, often 7.5 percent of pay when a cash balance plan is combined with a defined contribution plan.
• Minimum participation. Section 401(a)(26) requires the cash balance plan itself to provide meaningful benefits to at least the lesser of 50 employees or 40 percent of the workforce.
• Vesting. Cash balance plans must vest fully after three years of service.

The result is that staff receive real benefits. A well-built design keeps that cost in proportion to the owners' benefit, but it cannot make it disappear, and a plan sold on the premise that staff cost will be negligible has usually been designed badly.

The obligations that come with it

Required funding. An actuary determines the contribution range each year under Section 430. The maximum is generous. The minimum is not optional, and a missed minimum carries an excise tax and a filing obligation. Owners who may need to skip a year should hear that before adoption.

Investment results matter. If the trust earns more than the crediting rate, surplus builds, and that surplus has limited uses. If it earns less, the shortfall is made up through future contributions. Most plans are invested conservatively, with the target return set near the crediting rate rather than at the return the owner would choose for personal assets.

Deduction limits. When a cash balance plan is paired with a defined contribution plan and the cash balance plan is not covered by the PBGC, employer contributions to the defined contribution plan above 6 percent of pay count against a combined deduction limit of 25 percent of pay. Professional service employers with 25 or fewer active participants are generally exempt from PBGC coverage, so this limit applies to many small firms and the profit sharing contribution has to be sized with it in mind.

Permanency. The IRS expects a qualified plan to be intended as permanent. A plan adopted as a one-year deduction and terminated the next year invites a challenge to the deduction.

Annual administration. Each year requires an actuarial valuation, nondiscrimination and coverage testing, Form 5500 with Schedule SB, benefit statements and, for covered plans, PBGC premiums.

Questions to ask first

• Is the business's cash flow stable enough to make the minimum contribution in a weak year?
• How large is the gap in age and pay between the owners and the staff, and how many staff are there?
• What is the owners' time horizon before retirement, sale or a change in ownership?
• Is the business a professional service firm with 25 or fewer participants, which determines PBGC coverage and the deduction limit?
• Who will make the investment decisions, and do they understand that the target is the crediting rate?

We design, test and administer cash balance plans, prepare the plan documents and work directly with CPAs on contribution planning before the filing deadline.

This article is general information about the topics discussed and is not actuarial, legal or tax advice for any specific plan or employer.