Boost retirement benefits with a cash balance plan

Business owners may not be able to set aside as much as they would like in tax-advantaged retirement plans. Typically, owners are older and more highly compensated than their employees, but restrictions on contributions to 401(k) and profit-sharing plans can hamper retirement-planning efforts. One solution may be a cash balance plan.

Defined benefits with a twist

The two most popular qualified retirement plans — 401(k) and profit-sharing plans — are defined contribution plans. These plans specify the amount that goes into an employee’s retirement account today, typically a percentage of compensation or a specific dollar amount.

In contrast, a cash balance plan is a defined benefit plan, which specifies the amount a participant will receive in retirement. But unlike traditional defined benefit plans, such as pensions, cash balance plans express those benefits in the form of a 401(k)-style account balance, rather than a formula tied to years of service and salary history. The plan allocates annual “pay credits” and “interest credits” to hypothetical employee accounts. This approach allows participants to earn benefits more uniformly over their careers, and provides a clearer picture of benefits than a traditional pension plan.

Benefits for business owners

Establishing a cash balance plan or adding one to coordinate with an existing 401(k) or profit sharing plan can provide significant advantages for business owners — particularly those who are behind on their retirement savings. In 2017, the IRS limits employer contributions and employee deferrals to defined contribution plans to $54,000 ($60,000 for employees age 50 or older). Nondiscrimination rules, which prevent a plan from unfairly favoring highly compensated employees (HCEs), can hamper an owner’s contributions even further.

Cash balance plans aren’t bound by these limits. Instead, as defined benefit plans, they’re subject to a cap on annual benefit payouts in retirement (currently, $215,000), and the nondiscrimination rules require that only benefits for HCEs and non-HCEs be comparable. Contributions may be as high as necessary to fund those benefits. Therefore, a company may make sizable contributions on behalf of owner/employees approaching retirement (often as much as three or four times defined contribution limits), and relatively smaller contributions on behalf of younger, lower-paid employees. These funding contributions are determined by an actuary on an annual basis and are considered independent of contributions to any existing defined contribution plans.

Of course, there are potential risks to cash balance plans as well. Unlike profit-sharing plans, you can’t reduce or suspend contributions to these defined benefit plans during financially difficult years. Similarly, investment performance within the plan may impact your ability or need to make funding contributions. So, if you do choose to implement one, it will be critical to ensure that your company’s cash flow will be steady enough to meet its funding obligations.

Be prepared

Although cash balance plans can be more expensive than defined contribution plans due to the additional administrative intricacies, they’re a great way to turbocharge your retirement savings. Work with your CPA and retirement advisors to determine if one may be right for you.