Most retirement plans fall into one of two general categories: defined benefit plans or defined contribution plans. Both provide retirement benefits, but they differ in the way benefits are calculated and funded. A cash balance plan is a cross between a defined benefit plan and a defined contribution plan.
Cash balance plans are like traditional defined benefit pension plans with a 401(k) twist. As in a traditional DB plan, investments are professionally managed and participants are promised a certain benefit at retirement. As one might expect, since a benefit is promised, the use of an actuary on an annual basis is needed. Since an actuary is needed and a benefit is promised, these plans usually require PBGC (Pension Benefit Guaranty Corporation) coverage. Investment risk is borne entirely by the employer. The aforementioned promised benefit is stated as a 401(k) style account balance rather than an income stream.
Business owners should expect to make contributions for rank-and-file employees amounting to roughly 5% to 8% of pay. The amount that a business owner is able to contribute to a cash balance plan is dependent on one’s age and the makeup of their workforce. The payoff here is that a business owner aged 63 years in 2016 could contribute a maximum of $256,000 to a cash balance plan. If desired, they are also able to contribute to a 401(k) plan, and if that 401(k) includes a profit sharing feature, they may be able to contribute an additional $59,000 for a total tax-deferred contribution of $315,000.
In addition to the annual contribution, participant accounts also receive an “interest credit” each year. This concept is easily the most complicated and most difficult component of cash balance plans to wrap one’s mind around. This requirement is in effect so that hybrid plans (like cash balance plans) satisfy Code Section 411(b)(5)(B) prohibiting age discrimination. The IRS recently released an exclusive list of approved methods for interest credit. Below is the complete list of interest credits that satisfy the “market rate of return” requirement, effective for plan years beginning on or after January 1, 2016:
- A flat, fixed rate up to 6%.
- Various government bond-based indices, with certain associated margins.
- Any of the three corporate bond segments under Code Sec. 417(e) rules.
- Certain widely used cost-of-living indices, such as various CPI measures, which may be increased by up to 300 basis points.
- Rate of return on plan assets, including positive and negative returns, assuming they are diversified to minimize volatility. A cumulative floor of up to 3% is permitted.
- Certain annuity contract rates.
- Rate of return of a designated registered investment contract. A cumulative floor of up to 3% is permitted.
Methods of Withdrawal
At retirement, participants in a cash balance plan can choose to annuitize their benefit, or take a lump sum distribution that can generally be rolled over. These plans generally offer a degree of portability as long as one is vested in the benefit.
Due to the complexity of the plans and annual actuarial needs, cash balance plans are not considered a low-cost retirement plan option. Typical costs include $2,000 to $5,000 in setup fees and $2,000 to $10,000 in annual administration fees. The partner that Claris utilizes for these plans has fees that are very near the bottom of this range.
Small business owners, doctors, dentists, and other high income professionals who are closer to the end of their career have the potential to benefit greatly from these types of plans. As long as an entity has strong cash flows and is committed to contributing to a retirement plan for a number of years, there is no better way for highly compensated business owners and professionals to save massive amounts of money in a tax-deferred fashion.
Contact Claris if you have any questions on cash balance plans.