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While a 401(k) plan is a great savings vehicle, did you know there is a type of qualified retirement plan that will allow you to contribute significantly more than the maximum allowed in a stand-alone 401(k) profit sharing plan?
We are all familiar with defined contribution plans (e.g., 401(k) and profit sharing plans). You are probably also familiar with traditional defined benefit plans, or pension plans, historically sponsored by large companies to provide monthly retirement benefits to their retirees. For business owners that are looking for large tax deductions, accelerated retirement savings, and additional flexibility, another type of defined benefit plan, a cash balance plan, may be the perfect solution.
As mentioned above, a cash balance plan is a type of defined benefit plan. In general, defined benefit plans provide a specific benefit at retirement to participants. While traditional defined benefit plans define an employee’s benefit as a series of monthly payments for life to begin at retirement, cash balance plans state the benefit as a hypothetical account balance. Each year, this hypothetical account is credited with following:
The accounts in a cash balance plan are referred to as hypothetical because, unlike defined contribution plans, the plan assets are held in a pooled account managed by the employer, or an investment manager appointed by the employer. The hypothetical account balances are an attractive feature of cash balance plans because these accounts tend to be easier for participants to understand, as the annual benefit statements reflect the value of their account, similar to 401(k) profit sharing plan account statements.
Unlike a 401(k) profit sharing plan, a defined benefit plan guarantees the benefit each participant will ultimately receive. The plan’s actuary calculates the benefits earned each year based on the terms of the plan document, which in turn determines the required employer contribution due to the plan.
When a participant becomes entitled to receive their benefit from a cash balance plan, the benefits are defined in terms of an account balance and can be paid as an annuity based on that account balance. In many cash balance plans, the participant also has the option (with consent from his or her spouse) to take a lump sum benefit that can be rolled over into an IRA or to another employer’s plan.
In most cases, cash balance plans work best when paired with a 401(k) profit sharing plan. To optimize the combined plan design, it’s possible that certain provisions in your current plan may need to be amended. This is especially true if the cash balance plan covers non-owner employees. Due to the large benefits that are typically earned by the owner and/or other key employees, the combined plans must pass certain nondiscrimination tests. These tests are more easily passed when employer contributions are provided to the staff under the 401(k) profit sharing plan as safe harbor nonelective and profit sharing contributions. While company contributions in a stand-alone 401(k) profit sharing plan may be discretionary, when combined with a cash balance plan, these contributions become required as well, since without them, the combined plans will likely not pass all required nondiscrimination tests.
Unfortunately, the answer to this question is no. The first question to ask yourself is if you wish to make contributions in excess of the defined contribution limit ($58,000 or $64,500 for participants over age 50 for 2021). If the answer to this is yes, then the demographics of the employer must be considered. Since the maximum contributions are age dependent, cash balance plans typically work best when targeted employees are older than the average age of other staff members. And maybe most importantly – do you anticipate consistent profits that will allow you to fund all required contributions for the foreseeable future?
If you’ve decided setting up a cash balance plan sounds like the perfect way to meet your retirement goals and attract and retain quality employees, you may be right! However, as good as this sounds, there are many important factors to consider before jumping in. Here are a few key considerations:
For employers that desire increased retirement savings and tax deductions, cash balance plans may be the perfect addition to their employee benefit program. However, as previously mentioned, they are not a good fit for everyone. It’s important to work with an experienced service provider to determine if a cash balance plan is right for you.
© 2021 Benefit Insights, LLC. All Rights Reserved.
© 2021 Benefit Insights, LLC. All Rights Reserved.© 2021 Benefit Insights, LLC. All Rights Reserved.© 2021 Benefit Insights, LLC. All Rights Reserved.