A cash balance retirement plan is more expensive to set up and administer, but the tax benefits might make it worthwhile.
Quick Overview of Cash Balance Plans
A cash balance plan is a defined benefit retirement plan, which means that the amount you receive at retirement is specified. Under this type of plan there is an account for each individual in the plan, much like a 401(k) plan, and the amount of your contributions as well as the earnings on the plan’s investments are credited to your account based on the plan’s predetermined amounts.
What Makes This Different from a 410(k) Plan?
In a nutshell, a cash balance plan credits your account with a set percentage of your salary each year (e.g., 5%) plus a set interest rate instead of a retirement benefit based on a formula accounting for length of employment and five previous years of average salary. At the end of every year, cash balance plan participants get a statement detailing the hypothetical value of their account and an estimate of the monthly income payout (or lump sum) at age 65.
An actuary maintains the plan and is responsible for making sure that everyone who participates in the plan is properly credited for contributions and earnings. When you retire, the balance in your plan is converted to an annuity and taken as lump sum or as a series of periodic payments. If you leave the company before you retire, you can take the vested portion of your plan balance with you.
What Are the Benefits of a Cash Balance Plan?
There are a few substantial benefits to this type of retirement plan. First, any contributions to the plan reduce ordinary income, which reduces taxes dollar for dollar. Second, the plan assets are protected in bankruptcy from creditors. This means that your retirement fund cannot be touched in a bankruptcy proceeding and will remain yours until you start making withdrawals.
Perhaps the biggest benefit for Baby Boomer business owners is that a cash balance plan can turbocharge their retirement savings, especially if those savings have not been sufficient. Cash balance plans have generous contribution limits: well over $200,000 annually in pre-tax contributions, compared to 401(k) employer and employee contributions, which are limited to $57,500.
Who Can Benefit?
There are several different types of individuals and organizations who could benefit from having a cash balance pension plan. These include:
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Business owners or members of a partnership who want to contribute more than $50,000 to their retirement accounts
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Companies that regularly contribute (or plan to contribute) more than three to four percent to an employee’s plan
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Companies with consistent profit patterns
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Business owners or partners in a partnership who are over 40 and need to catch up on their retirement savings
Candidates for a Cash Balance Plan
Highly profitable companies of all types and sizes
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Usually indicated by the owner's desire for a larger tax deduction
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Principals earning more than $260,000 per year
Family businesses
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A cash balance plan can be used as a component of succession planning
Closely-held businesses
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Several owners want a greatly enhanced retirement plan
Law firms of all sizes
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Tax deferral and asset protection are often very important to this profession, along with a highly competitive retirement package to help attract and retain top talent
Medical groups of all sizes
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Tax deferral and asset protection are often very important to this profession
Professional firms of all types
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CPAs, engineers, architects, financial services firms, dentists, management consultants and others
Older owners who have delayed saving for retirement
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They need to squeeze 20 years of saving into 10
Those who highly value asset protection
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ERISA protects all qualified plan assets from creditors in the event of bankruptcy or lawsuit
Those who want an enhanced benefits package for executives
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They want to attract and retain high caliber employees
Sole proprietors with income exceeding $260,000 per year
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All entity types apply
Source: Cash Balance Design
It’s Not All Wine and Roses
In a typical 401(k) plan, businesses typically contribute about 3% of pay, but these contributions could easily rise to roughly 5-8% of pay under a cash balance plan. It can also be more costly because each year an actuary must certify that the plan is properly funded, on top of annual administration and investment management fees.
However, for many older business owners, the tax benefits can easily outweigh the increases in contributions and costs.
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