Saving for retirement throughout your career helps you work towards having the lifestyle you desire when the time comes to stop working. While traditional 401(k) retirement plans are commonplace at most companies, certain employers may also offer a cash balance plan option. Below we dig into the details of cash balance plans for employees and business owners so you can weigh your options.
What is a cash balance plan?
A cash balance plan is a type of defined benefit retirement plan. Under a cash balance plan, employees will receive a stated amount upon retirement. These plans are recognized by the IRS as a qualified retirement plan, meaning they qualify for both tax deferral and creditor protection. A cash balance plan can be a stand-alone retirement plan but can also be paired with a 401(k) plan.
What is the difference between a cash balance plan and 401(k)?
Cash balance plans differ in a few key ways from 401(k) plans. The first is participation. Under a cash balance plan, there are no employee contributions. Rather, employers contribute a “pay credit” which is generally a percentage of the employee’s salary. The employers will also contribute an “interest credit” which may be a fixed rate or variable rate tied to something such as U.S. Treasury yield rates. Unlike a 401(k) plan, the employer bears the investment risk. Most cash balance plans are guaranteed by the Pension Benefit Guaranty Corporation, so employers must monitor account balances to ensure proper funding is met. Cash balance plans are also required to offer employees the ability to receive their benefits as either a lifetime annuity upon retirement or as a lump sum, which is then usually rolled into an IRA account.
Cash balance plans are similar to 401(k) plans in that each employee has an individual account. However, unlike a 401(k), the balance shown is a hypothetical amount. The balance doesn’t show actual gains and losses since the employer bears the investment risk. Like 401(k) plans, cash balance plans can also be taken with an employee if they switch jobs. The amount in their plan can be rolled into an IRA or transferred to their new employer’s 401(k) plan.
What are the pros and cons of cash balance plans?
Benefits of a cash balance plan include:
- The opportunity to make pretax contributions
- Higher contribution limits compared to 401(k) plans or an IRA. The contribution limit is age-weighted, meaning older individuals can contribute larger amounts as they draw closer to retirement
On the downside:
- Cash balance plans usually have limited growth since funds are invested more conservatively because the employer bears the risk
- Higher administrative costs than a 401(k) plan because they require an actuary to annually certify the account is properly funded
How do cash balance plans work for business owners?
For some business owners, cash balance plans can offer tax benefits beyond those available from a 401(k) plan. Contributions to the plan are deductible as an above the line deduction and reduce a business’s taxable income. Prime candidates for cash balance plans are established business owners and partners who want to make significant contributions toward saving for retirement each year. Cash balance plans can be an excellent way for business owners to build retirement funds quickly while offering tax benefits for their business.
Anders Family Wealth and Estate Planning advisors work with our affiliate company, Claris Advisors, to help clients determine the right tax-advantaged retirement strategies based on their goals. Contact Anders below to get started.All Insights