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Cash Balance Plans 101: What Financial Advisors Need to Know

Cash Balance Plans 101: What Financial Advisors Need to KnowCash balance plans can be a remarkable opportunity for small to mid-sized business owners, helping to accelerate their retirement savings and reduce year-end tax liability.
Popularity of cash balance plans has surged in recent years. They now cover more than 10 million employees and encompass about $1 trillion in assets. Remarkably, most of the growth in cash balance plans has occurred among small to mid-sized businesses (National Cash Balance Research Report, Kravitz, 2017).
These plans aren’t new. Cash balance plans have been around since the late 1980s. They are a part of the Internal Revenue Code, have passed the muster of the U.S. courts, and were one of the key topics written into the Pension Protection Act of 2006 (PPA ’06) by Congress. These plans became especially attractive to small business owners after the passing of the Economic Growth & Tax Relief Reconciliation Act of 2001, which, among many things, expanded pension-funding limits and created the opportunity to pair these plans with more familiar 401(k) programs. PPA ‘06 further solidified cash balance plan opportunities, in addition to providing clarification to questions and issues that plan sponsors and benefit professionals had posed since their early adoption.

What is a cash balance plan?

A cash balance plan, also known as a hybrid retirement plan, is a type of defined benefit plan sponsored by an employer. Under a traditional pension plan, participants usually accumulate a fixed monthly benefit, based on a formula factoring in salaries and tenure.  On the other hand, cash balance plans do not promise a fixed monthly benefit, but rather guarantee a lump sum which can be distributed in full or rolled over into an IRA at retirement.
The funding limits and rules that apply to pension plans are applicable to cash balance plans. However, unlike a traditional pension plan, a cash balance plan looks and feels like a 401(k) plan—a retirement program that most have become accustomed to seeing in the workplace. While similar to a 401(k) on the surface, cash balance plans frequently allow contributions far exceeding the limits prescribed to 401(k)s. Depending on age and income, these plans can accommodate a contribution between $60,000 and $200,000+, making a positive impact on both retirement accumulation and tax liability.
Cash balance plans are particularly effective for small business owners who are looking for larger tax deductions and/or accelerated retirement savings. Employers can combine a cash balance plan with 401(k) profit sharing plans to maximize tax-deductible contributions.

How do cash balance plans work?

Similar to a 401(k) or profit sharing plan, participants have a theoretical account.  However, the plan is managed as one commingled trust account rather than individual accounts.
Typically, a participant’s account is credited each year with a “pay credit” (such as 5% of compensation from their employer) and an “interest credit” (either a fixed rate or variable rate that is linked to an index as the one-year Treasury bill rate). The plan’s document will specify the contribution to be credited to each participant and the investment earnings to be credited based on those contributions.  As with most defined benefit plans, there are no participant contributions.
Participants receive an annual statement of their account balance which includes beginning-of-year account balance, earnings for the year, employer allocation, and an end-of-year account balance.

How are cash balance plans funded?

The plan’s actuary, who calculates the amount of funding based on the plan’s crediting formula, performance of plan assets, and other actuarial factors, determines the cash balance plan contributions annually. Because cash balance plans are a type of defined benefit plan, if plan assets do not perform in line with the interest expectation in the plan document (crediting rate), the employer is responsible for making up the difference. Conversely, returns in excess of the plan’s crediting rate will tend to reduce the contribution.
For that reason, when considering implementing a cash balance plan, it is very important to determine an appropriate funding range and to design an investment portfolio with a level of risk appropriate for the plan. Cash balance plan assets should be invested conservatively, so the investments measure up to liabilities of the plan as much as possible. This conservative approach may be compensated by investing other assets (e.g., the 401(k) account) more aggressively, when appropriate.

How is the money distributed and when is it taxed?

Cash balance plans, especially in small business situations, typically allows a lump sum distribution at retirement, which can be annuitized or rolled over to an IRA to retain its tax-preferred status. Account balances then become subject to IRA distribution rules with ordinary income tax payable on amounts distributed. Distributions before age 59½ are subject to a 10% early withdrawal penalty, unless an exception applies.
The health care reform signed into law at the end of March 2010 imposed new Medicare taxes effective in 2013. Individuals with earnings in excess of $200,000 and married taxpayers filing a joint return with earned income greater than $250,000 are now required to pay additional payroll tax of 0.9%, and a new 3.8% tax on investment income.
Because employer contributions to retirement plans are not subject to payroll tax and the net investment income under this recent legislation does not include distributions from qualified retirement plans and IRAs, these new taxes do not apply to cash balance plan contributions or distributions. This makes cash balance plans very attractive for those seeking to quickly build up their retirement savings in a tax-efficient environment, reduce current tax liability and minimize taxes on withdrawals.

What happens if the funding goals differ between business partners?

One of the unique advantages of cash balance plans is that they can elegantly accommodate the varying savings needs of business partners. For instance, if one is interested in increasing their contributions to $100,000, while their partner’s funding objective falls within the limit applicable to a profit-sharing plan, a cash balance plan can be designed in a manner that will allow both business owners to reach their funding goals. If funding objectives change later, then the plan formula may be amended accordingly to match the needs.

Is your client considering selling all or a portion of their business?

This may be yet another opportunity to utilize a cash balance plan with payments being directed to fund the seller’s retirement and reduce the tax exposure both today and when ready to distribute plan assets. This strategy has been successfully utilized by organizations with varying ownership paradigms: from multiple senior partners transitioning their ownership shares to junior partners, to situations when the ownership changes within a family business.

Does your client already sponsor a retirement plan?

Each situation differs based on the unique characteristics of the plan sponsor, employee makeup and personal financial objectives. In many cases, however, establishing a cash balance plan alongside an existing 401(k) plan may prove more advantageous. For example, it may allow a business to significantly increase key employee contribution allocation while only marginally increasing other employee costs, and, in some instances, reducing them.

What are the key advantages of cash balance plans?

Cash balance plans work very well with businesses that have multiple owners; you can track contributions to specific participants more easily than in a traditional defined benefit plan. A business that installs a cash balance plan can:

  • Provide easier to understand account balances for employees
  • Retirement savings may be accelerated for targeted employees
  • Participants do not bear the investment risk
  • Tiered benefit levels for varying levels of ownership
  • Generally less volatile and less expensive than traditional defined benefit plans


Is a cash balance plan right for your client?

If your client needs to catch up on retirement savings or would like to increase her nest egg, cash balance plans may be a desirable option. Your client may be a good candidate for a cash balance plan if:

  • The client is able to contribute more than $70,000 a year, including current retirement savings
  • The business has a consistent profit pattern and available surplus
  • The workforce is generally younger than the ownership
  • Key beneficiaries are in the 45-60 age range (for businesses without employees, age becomes less of a factor)
  • Business owners are willing to contribute five to seven percent of pay to the staff
  • Businesses with profit-sharing plans that would like to add a 401(k) feature in the current year

For a successful business owner, cash balance plans may offer substantial advantages, including tax management, retirement security management and asset protection.

For discussion purposes only and in no way represents legal or tax advice.  A cash balance play may not be appropriate in all cases.  For advice regarding your specific circumstances, the services of an appropriate legal or tax advisor should be sought. Cetera® Retirement Plan Specialists

About Cetera® Advisors

Cetera Advisors LLC is an independent broker-dealer and registered investment adviser (RIA) firm offering efficient and convenient access to an extensive network of people, products and services to financial professionals. As part of Cetera Financial Group®, a leading network of independent retail broker-dealers, the firm is able to offer all the benefits of a large, well-capitalized broker-dealer, including innovative technology, leading wealth management and advisory platforms, and comprehensive broker-dealer and RIA services, with the personal relationships often found only at a boutique firm.

Cetera Advisors is a member of the Securities Investor Protection Corporation (SIPC) and a member of the Financial Industry Regulatory Authority, Inc. (FINRA). For more information, visit ceteraadvisors.com.

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