Cash Balance Plans
Many business owners and partners of firms are looking for larger tax deductions and accelerated retirement savings. Cash balance plans can help provide above-the-line deductions that directly reduce ordinary income dollar for dollar.
What is a cash balance plan?
A cash balance plan is an IRS-qualified retirement plan known as a “hybrid” plan. Each employee, or participant, receives a contribution to an account and it grows in two ways: by an employer contribution and by an interest credit, which is guaranteed rather than dependent on the plan’s investment performance.
The annual interest credit is guaranteed and is not dependent on the plan’s investment performance. The interest credit is usually tied to the 30-year treasury rate (as defined by the IRS), which has been 3 to 4 percent in recent years. Plan assets are pooled and invested by the trustee or investment manager. If the plan’s investment earnings exceed the guaranteed rate, the excess will be used to reduce future employer contributions. This will not affect the amount that is credited to the participant’s account. Conversely, if the plan’s investment earnings are less than the guaranteed rate, then future employer contributions will be increased. This makeup is typically spread out over seven years. A wide range of investment vehicles can be used by the plan sponsor to achieve the interest crediting rate.
What are the benefits of a cash balance plan?
Cash balance contributions reduce both taxable income and adjusted gross income, so high income earners may move into a lower tax bracket. All of the following taxes may be reduced or eliminated by contributing to a cash balance plan:
- Investment Tax: An additional 3.8% tax on unearned net income is imposed on individual earning over $200,000 (or $250,000 for married couples). The surtax is in addition to the capital gains and dividend tax of 15%, 20% for high earners.
- Top Marginal Income: The top marginal tax rate is 37% for individuals earning over $500,000 (or $600,000 for married couples). A Cash Balance contribution reducing income for a married couple below $600,000 will result in tax savings plus a reduction in the marginal income tax rate!
- Medicare Tax: There is an additional 0.9% Medicare payroll tax on income above $200,000 (or $250,000 for married couples).
- Phase-Out of Tax Deductions: The ability to itemize certain deductions is phased out for individuals earning over $200,000 for individuals making more than $250,000 (or $300,000 for married couples)
Cash balance plans ultimately help employers and participants save more money, with significantly higher, tax-deferred contribution limits and major tax deductions.
Who may establish a cash balance plan?
Ideal cash balance candidates include:
- Principals seeking a tax deduction of more than $50,000 or making more than $250,000 per year
- Highly profitable companies of all types and sizes
- Successful family businesses and closely held businesses
- CPA and law firms, medical groups and professional firms
- Older owners who need to squeeze 20 years of retirement saving into 10
Who may participate in a cash balance plan?
Both employers and employees may participate in this plan. Each participant may have a different amount contributed for them. After designing more than 1,000 cash balance plans, we have found that the following are typically good candidates:
- Partners or owners that desire to contribute more than $50,000 a year to their retirement accounts
- Many professionals and entrepreneurs neglect their personal retirement savings while they’re building their practice or their company. They often have a need to catch up on years of retirement savings. Adding a cash balance plan allows them to rapidly accelerate savings with pre-tax contributions as high as $240,000, depending on their age.
- Companies already contributing 3–4 percent to employees, or at least that are willing to do so. While cash balance plans are often established for the benefit of key executives and other highly compensated employees, other employees benefit as well. The plan normally provides a minimum contribution between 5 and 7.5 percent of pay for staff in the cash balance plan or a separate profit-sharing 401(k).
- Companies that have demonstrated consistent profit patterns. Because a cash balance plan is a pension plan with required annual contributions, consistent cash flow and profit are very important.
- Partners or owners over 40 years of age who desire to “catch up” or accelerate their pension savings. Maximum amounts allowed in cash balance plans are age-dependent. The older the participant, the faster he or she can accelerate his or her savings.
How do I start a cash balance plan?
- Adopt a written plan, called the plan document, which outlines its day-to-day operations.
- Identify a plan provider and/or trust for the plan’s assets and investments.
- Select a recordkeeper or recordkeeping system to track contributions, earnings and losses, and distributions. This person or entity will also help prepare the annual return, which must be filed with the federal government.
- Select a third party administrator to maintain the plan document, fulfill daily tasks and ensure compliance with federal regulations. Your financial advisor may choose a third-party administrator and/or recordkeeper on your behalf.
- Provide eligible employees, or plan participants, with a summary plan document (SPD), which is the document that outlines who can participate and how the plan works.
If the plan allocates responsibilities for performing administrative functions to other parties, such allocation must identify who is responsible for ensuring compliance with the requirements of the tax code, including compliance requirements for loans and distributions.
In the case of funding through multiple financial institutions, the employer may adopt a single written plan to coordinate administration among the financial institutions, rather than having a separate document for each issuer.