Blog
April 24, 2024
Background on Defined Benefit Plans Will Be Helpful
A Cash Balance Plan is a type of defined benefit plan that defines the benefit in terms that are more characteristic of a defined contribution plan, such as 401k. A cash balance plan defines the promised benefit in terms of a stated account balance.
Background on How a Defined Benefit Plan Works and How It Is Helpful
A Defined Benefit Plan states the benefit in terms of a monthly benefit or pension at retirement generally at age 62. The cash balance plan converts this benefit to a hypothetical account balance. These plans allow for considerably larger contributions than profit sharing and 401(k) plans. However, they are often used in tandem. The result is usually five to over ten times the amount of money owners can deposit or contribute to a 401(k).
As of 2023, the maximum benefit is a monthly benefit at age 62 of $22,083.33 per month, or $265,000 per year. This means at age 62 there will be enough money to provide the plan participant with this monthly pension for life. The invested cash will be $3,400,000. In lieu of a monthly benefit, the cash can be transferred to another employer plan, or to an individual retirement plan (IRA).
To achieve this benefit, a business owner or executive needs to have compensation that equals or exceeds $265,000 and participate in the plan for at least ten years. Less than ten years of participation reduces this benefit by 10% a year. The best result for a business owner is to take compensation at the government’s maximum allowable. This results in a better ratio of the owner’s benefit to everyone else’s benefit. The 2023 compensation maximum is $330,000.
When we establish a Cash Balance plan, we take the employer’s budget into account, or the maximum amount allowed along with other eligible employees to determine the cash contribution. We determine the contribution using defined benefit principles above, but convert the benefit to a cash balance, thus the name.
As in a 401(k) plan a Cash Balance plan maintains an account for each participant. The account grows annually in two ways. First, a contribution, and second, an interest credit that is guaranteed, rather than being dependent on the plan's investment performance.
Participant Accounts Grow Annually in Two Ways
- The company contribution (a percentage of pay or a flat dollar amount), is determined by a formula specified in the plan document.
- An annual interest credit. The rate of return is guaranteed and independent of the plan's investment performance. That rate changes each year, but it is typically equal to the yield on 30-year treasury bonds, which have hovered around five percent in recent years.
Investment earnings or losses will affect the plan contribution. The government says the employer will generally provide five percent interest credit on the total value of the invested money. This is offset by interest in investment earnings. If the earnings are greater than five percent, contributions may be reduced in the future. Conversely, if the plan earns less than five percent the employer makes up the difference.
When participants terminate employment, they are eligible to receive the vested portion of their account balance.
What About Plan Design and Associated Fees?
A common question is whether you can add a Cash Balance Plan to what you have already, and the answer is yes. We have many of these types of plans in combination with 401(k) plans, and this type of design does two things for a business owner. First, it increases the amount a business owner can tax defer. Second, it reduces the overall cost for their employees.
A Cash Balance Plan is more expensive to set-up and administer than a 401(k) plan. These plans must be certified by an actuary that is enrolled with the government. An actuary must follow very specific rules and be experienced enough to handle small businesses that need flexibility, and this can be quite a balancing act. However, the tax benefits of the Cash Balance plan will often significantly exceed the additional cost. Expenses will vary based on how many employees you have, and how creative BEI needs to be to accomplish your goals within the confines of the government’s regulations.
This presentation is a good start in providing some of the basics. Please contact one of our experienced BEI consultants for more information, or request a free proposal by email us at Planservices@benefitequity.com for call us at 714-480-1364.