Top 8 Cash Balance Pension Plan FAQs
Even with all the economic challenges that face the small business, owning a business is arguably the best path to a secure financial future for individuals. When a business is growing, often there are planning decisions for taxation and finances related to retirement accounts for owners and employees. When a business is doing quite well with owners seeking better choices for retirement planning, conversion of traditional plans to a cash balance pension plan can be smart for taxation and retirement reasons. Here are the top questions about cash balance pension plansi:
1 What is a cash balance plan?
Business owners usually choose between two types of pension plans:
- Defined Benefit – the defined benefit plan provides a specific benefit for each eligible employee.
- Defined Contribution – defined contribution plans specify the dollar amount of contributions to be made by the employer into employees’ retirement accounts. The amount of the benefit to the employee at retirement depends upon contributions plus the gains or losses of the account.
The cash balance plan combines features of the other two types of plans with a major benefit to high income owners that allows much higher contribution limits to the plan.
2 What are the contribution limits for cash balance plans?
For a business owner who wishes to fund the maximum lifetime benefit limit to a cash balance plan, the business owner’s annual tax-deductible contributions to the cash balance plan are typically in the range of $100,000 – $250,000 each year (depending on the business owner’s age and annual income)ii.
It is easy to see why converting existing traditional plans to a cash balance plan can help a successful business to further minimize taxes while building owner retirement accounts.
3 How do cash balance plans work?
The typical cash balance plan has the employer crediting each employee’s plan account with a “pay credit” each year. An example would be 5% of the employee’s compensation. In addition, there is an “interest credit.” This is either a fixed rate or a variable index-linked rate of interest. There is some risk to the employer in this respect, as the employer is guaranteeing this interest rate.
That is the contribution side. When it comes to benefits, they are defined in terms of the account balance. At the time of retirement, the employee can choose to receive a lump sum, or an annuity based on the balance of assets in the account.
4 What are the main differences of the cash balance plan?
While traditional retirement plans define the retirement benefit as a series of monthly payments for life, the cash balance plan defines the benefit in terms of a stated account balance. Also, the lure for most highly profitable businesses is the much higher deductible contribution limits for the owners.
5 What are the differences between the cash balance plan and the 401(k)?
While the main difference is that the cash balance plan is a defined benefit plan while the 401(k) is a defined contribution plan. There are four other differences:
- Participation – while the 401(k) plan involves the worker contributing some portion of their compensation to the plan, the cash balance plan does not.
- Investment Risks – in 401(k) plans the investment risks are borne by the employees and their choices of investment assets. In cash balance plans, the employer controls the investment of funds in the accounts. Because there are specific benefits promised to participants in the cash balance plan, the employer bears the risk of performance of the investments.
- Life Annuities – unlike the 401(k), the cash balance plan is required to offer the ability of the participant to receive their benefits in the form of lifetime annuities.
- Federal Guarantee – due to the fact that the cash balance plan is a defined benefit plan, the benefits are generally insured by a federal agency, often the PBGC, Pension Benefit Guaranty Corporation.
6 Does Federal law govern the cash balance plan?
There are three federal laws or acts that govern the setup and management of cash benefit plans:
- ERISA, Employee Retirement Income Security Act
- ADEA, Age Discrimination in Employment Act
- IRC, Internal Revenue Code
7 Are there special requirements in converting to a cash balance plan?
As with other retirement plan types, there are federal rules and regulations regarding closing or changing of qualified retirement accounts. There are notification requirements as well as other rules to protect the interests of the employees.
8 What happens to the assets in a plan that is converted to a cash balance plan?
When converting from another qualified retirement plan to a cash balance plan, the assets remain intact and continue to back all the plan’s pension benefits.
The Cash Balance Pension Plan option can be a great solution for high income business owners who want to maximize plan contributions to retirement accounts.