Is it Time to Consider a New Plan Design?
You may have heard about a “Cash Balance plan” and wondered whether it would be something advantageous for your business. A Cash Balance Defined Benefit plan operates differently from other types of traditional retirement plans like 401(k) Profit Sharing Plans, known as Defined Contribution plans. Often, when pairing a 401(k) Profit Sharing Plan and a Cash Balance Defined Benefit Plan together in a “combo plan” environment, we can optimize contributions and outcomes.
A Cash Balance Plan is a Defined Benefit Plan, which means it is subject to minimum funding requirements and required annual contributions. Unlike a Defined Contribution Plan that defines the contribution for that year, the Cash Balance Defined Benefit Plan is defining the benefit projected out to Normal Retirement and thus is not a year-to-year solution, but a long-term tax strategy.
The investment of Cash Balance plan assets are also different from a 401(k) Profit Sharing Plan and are managed by the employer or an investment manager appointed by the employer. Since Cash Balance Plans are a “benefit,” increases and decreases in the value of the actual plan’s investments do not directly affect the amount promised to employees. This means a Cash Balance defined benefit plan must be invested far more conservatively with an anticipated rate of return between 3-5% to project stable returns and not overly influence annual contribution ranges.
Who are Cash Balance plans best suited for?
Cash Balance plans are especially suited for self-employed or small business owners with high incomes who are already maximizing their Defined Contribution Plans. These plans allow high-earning business owners to save more than the $58,000 (2021) currently allowed for profit sharing/401(k) plans. Cash Balance plans have generous contribution limits creating the most significant deductions allowable under the tax code and will appeal to those concerned about their corporate tax liabilities.
Employer contributions to a Cash Balance plan could potentially be three to four times their profit sharing/401(k) contributions and will vary depending on age, income, employee payroll and how much is currently invested in the plan.
Most Cash Balance plans are designed for the primary benefit of owners or executives of a company. This has been especially true since the 2018 tax code changes under the Tax Cuts and Jobs act created opportunities for further tax savings with the 199A Deductions.
Some candidates include professional practices (doctors, lawyers, accountants, architects, agencies, family owned businesses, to name a few examples) who would like to minimize taxes by putting away their hard-earned dollars into tax-deferred accounts. Additionally, Cash Balance plans can be appropriate when the owner or executive-level employees are several years older than most of the non-highly compensated employees. For more specifics, it’s best to speak with us for a sample plan design proposal.
Cash Balance Defined Benefit Plans are great for not only tax deduction and wealth accumulation, but employee recruitment and retention.
Cash Balance Plans create a “hypothetical allocation” for each participant each year. That hypothetical allocation account is “credited” each year with an interest rate that is set forth in the plan document. Thus, from a participant’s perspective, a Cash Balance plan looks very similar to a defined contribution plan. A participant’s “hypothetical allocation” for a given year is then projected to the normal retirement age at the “crediting rate”. The projected lump sum resulting from the current year’s “hypothetical allocation” is then divided by an annuity factor to convert it into a “defined benefit”. The benefits and deductions can be just as high as a traditional defined benefit plan but they look and feel like a defined contribution plan to the plan participants.
This sounds too good to be true, so what’s the catch?
Downsides to sponsoring a Cash Balance plan include the need to commit to annual minimum funding levels over a period of 3-5 years, , investment management fees, and actuarial fees associated with the annual certification requirement showing that the plan is properly funded and reported. Typically, the tax savings are advantageous and outweigh any of the disadvantages.
What should I do next?
Plan design is largely dependent on the demographics of a business as well as the level of contributions with which the business is most comfortable. For these reasons, consulting with a third-party administrator is highly recommended. At CrossPlans, we will create customized illustrations using your company’s particular demographics to provide alternative plan designs for review and consideration.
Proper retirement plan design can help you fulfill your company’s retirement plan objectives, such as maximizing benefits to owners and key employees, tax deferral methods and efficient ways to allocate retirement plan dollars.
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