What is a Cash Balance Plan? The Complete Guide

We know that a lot of folks have questions regarding cash balance plans and how you can make them work for your business. It really is not that tough. There are several situations in which they work great for companies and some in which they don’t.

The plan definition is a critical component of a successful retirement program. It helps employees understand what they can expect when the time comes to withdraw their money from the plan. These plans are tax-advantaged plans that can be changed and amended by an employer only for valid economic reasons.

The amendments must be made before the employee works 1,000 hours during the plan year or within two and a half months after the end of the plan year. In addition, the employer cannot freeze or terminate the plan before the employee has worked for 1,000 hours.

What is a Cash Balance Plan?

One of the most crucial features of a plan is its ability to allow a participant to build massive retirement assets while still working for a company. The plan’s annuity option allows a participant to retire at any age without a minimum amount of contributions or withdrawals.

In a traditional pension plan, a participant can choose to take an annuity for the life of his or her career. However, with a plan, an individual is free to choose whether to accept a lump sum benefit or an annuity.

In a cash balance plan definition, it is important to understand the differences between the types of plans. First, a Cash Balance plan is an IRA-style account in which the employer contributes to the participant’s account. The money in this account accrues interest and is tax-deferred.

This means that an employer must meet specific requirements before it can start making contributions. If an employer is inexperienced with IRAs, it is crucial that they seek professional advice to ensure that the plan is the right fit for their employees.

The benefits of cash balance plans are many. For example, traditional pension plans require companies to maintain a fund for payouts indefinitely. This approach has created a system of underfunded pensions and an excessively large rainy day fund.

With a plan, however, a company only needs to contribute the funds into the participant’s account and can then use that extra cash flow to expand or grow the business.

How do the plans work?

A cash balance plan is a type of retirement plan that requires a company to make an annual contribution. The money is invested in the plan and attracts interest based on a percentage. This rate can be variable or fixed, but the IRS treasury interest rate is the same.

Therefore, a company can channel its investment into the reserve account if it gets better interest than the market rate. Otherwise, it will have to withdraw the money.

Unlike a traditional pension plan, a cash balance plan’s benefits are expressed in terms of the account’s current value. While this may not be as beneficial as traditional defined benefit plans, cash balance plans can still be attractive for many employees.

These types of retirement savings plans are generally much more flexible than traditional pensions and can be a good option for employees. This flexibility also allows employers to set up a cash balance plan that suits their specific employees.

A cash balance plan is similar to a traditional defined benefit plan in that it is designed to provide meaningful benefits to non-owner employees while also maximizing benefits for owners. The difference between a cash balance plan and a traditional defined benefit plan is the type of funding involved.

A plan uses an annual “funding range” in which contributions are tax-deductible. While a non-owner employee’s compensation is different than an owner, a non-owner’s income can be used as the basis for the calculation.

A plan can be difficult to implement. Many employers are unsure how to set up and manage a cash balance plan. While a 401k is an excellent choice for many employees, a cash balance plan has a few pitfalls.

For example, it may not be feasible to allocate money to the benefits of non-owners. The benefits of a plan can also be difficult to understand if you do not understand how it works.

The most important aspect of a cash balance plan is that it controls the cost of non-owner employees. Because the IRS has approved cash balance plans, businesses are encouraged to make as much money as possible in them.

While a cash balance plan is not a tax-free vehicle, it does have some benefits. If you’re an owner of a company, you may want to look into the plan. This is the type of retirement plan you should use for maximum tax benefits.

Best Companies For Cash Balance Plans

Strict IRS rules make cash balance plans better suited to small and medium-sized companies with an owner and few employees. The plans also work perfectly for medical or law firms by covering partners and lower-paid administrative employees.

A plan must fund the lesser of 40% of staff or 50 employees. It would be impractical for a large firm with thousands or millions of employees to implement a cash balance plan as only 50 employees would benefit. 

If your business can sustain a cash balance plan and you are nearing retirement but behind on retirement savings, you should enroll in one. A CBP will help you divert significant chunks of your business’ earnings as tax-deductible contributions to your and your employees’ retirement savings on a tax-deferred basis. The pre-tax contributions help to supercharge all the retirement accounts.

The Bottom Line

Cash balance plans allow you to share profits with your employees by making annual tax-deductible retirement contributions of significantly higher value than the 401(k) profit-sharing retirement plan maximum.

You gain tax benefits by reducing your pre-tax income after plan contribution deductions. You can also acquire significant retirement savings through tax deferment.

The plans offer additional benefits since you may pursue aggressive investments and earn above your interest credit rate if your firm has a high-risk tolerance. You can then use the profits to help fund the plan and create a surplus for yourself.

IRS and regulatory restrictions make cash balance plans best suited for small and medium-sized professional companies, including law firms and medical practices. 

Contact a certified third-party administrator (TPA) today and have their actuary review your small or medium-sized business’ suitability for a plan. The plan could have game-changing effects on your and your employees’ retirement planning and your tax-efficiency strategy.