United States

Cash balances plans may boost benefits for small business owners

INSIGHT ARTICLE  | 

Small business owners may dramatically increase their retirement benefits with a combination 401(k) cash balance plan.  While 401(k) plans are in wide use, cash balances plans and their potential for significant wealth accumulation for owners may be new to most people.  A cash balance plan works like this:  Each year, the employer credits each employee’s individual cash balance account with (1) a “compensation credit” usually based on a fixed dollar amount or a fixed percent of salary, plus (2) an “interest credit” amount based on a fixed or variable market rate (such as the yield on one-year Treasury note) based on the prior year account balance. 

Unlike a 401(k) plan, the cash balance account is a hypothetical account.  Under a cash balance plan, the plan is required to offer participants the option of taking their retirement benefit in the form of an annuity.  However, participants may elect to receive their account balances in the form of a lump sum (with spousal consent).  The participant’s account is increased annually by an interest credit designated in the plan.  It does not necessarily rise or fall with actual investment experience.  Although the cash balance plan is a defined benefit pension plan, it is a hybrid arrangement with characteristics of both a defined benefit pension plan and a defined contribution plan.

For example, let’s say that Amy, age 40, participates in a cash balance plan sponsored by her employer, Fantastic.  Amy’s hypothetical cash balance account is credited with a compensation credit set by Fantastic at 10 percent of compensation.  Amy’s annual eligible compensation is $150,000, so her compensation credit in the first year of the plan equals $15,000.  Because in year one, Amy does not have a prior year account balance, typically the plan will not provide an interest credit. In the second year, Amy again receives a contribution credit of $15,000 ($150,000 × 10 percent), plus an interest credit based on her beginning account balance. If the plan uses a fixed rate interest credit of five percent, her interest credit for year two will be $750, which is five percent of her $15,000 opening balance, as illustrated below: 

Year one of the cash balance plan:

Amy's beginning balance

$0

Amy’s contribution credit (10% of comp)

$15,000

No interest credit in year one

$0            

Amy’s ending balance for year one

$15,000


Year two of the cash balance plan:

Amy's beginning balance

$15,000

Amy’s contribution credit allocation 

$15,000

Interest credit on beginning balance @ 5% 

$750            

Amy’s ending balance for year two

$30,750

 

Why a Cash Balance Plan? 

The advantages of a cash balance plan for owners are:

  • Higher maximum annual benefit limits, allowing higher benefit accruals,
  • An increase in benefits as a participant ages, and
  • Easier understanding for participants.

Higher Maximum Benefit Limits. The maximum annual benefit limit for a defined benefit pension plan is $225,000 (in 2019, as indexed), and the maximum annual benefit limit for a defined contribution plan with a 401(k) feature is $56,000, plus a $6,000 catch-up contribution for those over age 50 (in 2019, as indexed). The $19,000 annual limit on elective deferrals in the 401(k) feature of the plan, plus a catch up contribution limit of $6,000 still apply; the combined limit for a profit sharing plan with a 401(k) feature is a total of $56,000 ($62,000 if the participant is 50 or older). Because the cash balance plan is a defined benefit pension plan, the maximum annual limit for a cash balance plan applies in addition to the maximum annual limit for a defined contribution plan.   

Here’s an example:

A professional services firm with two very highly paid shareholders, one of their spouses, two other professionals, and 10 staff employees sets up a new cash balance plan. The employer has adopted a safe harbor 401(k) profit sharing plan using the three percent of pay fully vested basic contribution for all employees. The firm is considering amending the plan to maximize the owner’s profit sharing amount and adding a cash balance plan for the two owners. The owners want to know how much they can contribute and what the additional cost for contributions to the staff will be. 

 

Name
Current age
Salary
401(K) profit sharing
Cash balance
Total
% of total
Owner 1 55 $280,000 $62,000 $205,000 $267,000  
Owner 2 50  280,000 62,000 160,000 222,000  
Spouse 1 50  50,000 45,000 - 45,000  
Owner totals:   $610,000     $534,000 91%
Executive 1 55  280,000 8,400 - 8,400  
Executive 2 60 175,000 5,250 - 5,250  
Executive totals:    $455,000     $13,650 2%
Employee 1 50  60,000 4,200 1,200 5,400  
Employee 2 55  58,000 4,060 1,160 5,220  
Employee 3 60  42,000 2,940 840 3,780  
Employee 4 40  50,000 3,500 1,000 4,500  
Employee 5 35  45,000 3,150 900 4,050  
Employee 6 30  60,000 4,200 1,200 5,400  
Employee 7 28  40,000 2,800 800 3,600  
Employee 8 23  35,000 2,450 700 3,150  
Employee 9 22  28,000 1,960 560 2,520  
Employee 10 20  20,000 1,400 400 1,800  
Staff totals:   $438,000     $39,420 7%
Grand totals:    $1,503,000     $587,070  

 

Summary of tax savings  
Total contribution for owners and employees 587,070
Less: Estimated tax savings @ 40% for the professional service firm (234,828)
Net to the professional service firm after tax cost 352,242

 

By amending the allocation provisions of the profit sharing plan and adopting a cash balance plan, the owners have substantially increased their retirement saving (with additional contributions of $205,000 and $160,000 respectively) while simultaneously improving the retirement plan for their staff employees. 

Cash balance plans generally favor older participants because older participants have fewer years until normal retirement age so calculated contributions can be higher to achieve the same retirement benefit level as for younger employees.  The cash balance plan accrued benefit may also allow for a greater disparity in benefits for business owners who may be older than a generally younger workforce, subject to certain restrictions designed to prevent age discrimination. 

A cash balance plan is subject to the same non-discrimination rules applicable to other tax-qualified retirement plans with respect to eligibility, coverage, and other benefits, rights and features under sections 401(a)(4) and 410(b).  Further, a cash balance plan may have limits on vesting requirements.  

As explained above, a 401(k) cash balance plan may be an opportunity to boost benefits for small business owners.  Here are some next steps:

  • Identify small business owners with a business that employs employees;
  • Determine what kinds of retirement benefits the owner already offers to employees, if any;
  • If the owner does not offer any retirement plans to employees, discuss the advantages to the owner of accumulating a retirement benefit on a tax-free basis with a 401(k) cash balance plan;
  • If the owner already offers a 401(k) plan or profit sharing plan, discuss the contribution limitations that apply to the owner and how a 401(k) cash balance plan may provide a higher maximum benefit on a tax-free basis.

 

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