Business owners want larger tax deductions and increased savings. With the rising cost of living, the need to save for the future and the desire to pass on wealth require savvy ways of accumulating assets. A cash balance plan is one of the best and most effective solutions for these situations.
Benefits of Cash Balance Plans
Cash balance plans offer benefits beyond the larger tax deductions and accelerated retirement savings. Cash balance plans are communicated in terms of an “account balance”, so they are more easily understood, and appreciated by employees. For example, an employee can be told that they have $7,000 in the cash balance plan. Cash balance plans take the mystery out of the employee pension plans.
Cash balance plans are also more predictable than traditional defined benefit pension plans. A participant’s benefits can be projected based on plan provisions to a future date with relative ease. No more complex explanations.
What makes Cash Balance plans so attractive to small business owners?
Reduced Taxes: After staff costs, taxes are usually the largest expense for small businesses. Cash balance plans help owners with a significant tax deduction for contributions made to the plan, plus they provide generous tax-deferred retirement contributions for themselves. So, it’s a win-win, the owners pay less in taxes and at the same time they dramatically increase their tax-deferred savings.
Accelerate retirement savings: Higher contribution limits allow older owners to potentially accelerate 20 years of savings into 10. Owners can typically double or triple the pre-tax deferrals they were able to make in a 401(k) profit sharing plan. This is one of the only ways to accumulate such large sums of money that are tax deductible and grow tax deferred.
Attracting and retaining talent: In a tight labor market, cash balance plans are more appealing to employees than typical 401(k) plans alone due to the additional amounts that can be saved for retirement, giving small business owners a competitive advantage in staff recruitment and retention.
Asset protection: cash balance assets are protected in the event of a lawsuit or bankruptcy.
How do Cash Balance Plans Work?
In a cash balance plan, a theoretical account balance (TAB) is maintained on behalf of each participant. So, each participant in the plan has a TAB that resembles that of a 401(k) plan.
On an annual basis the TAB is credited with a “pay credit” and an “interest credit”. The pay credit is typically a percentage of pay and can vary by employee. The interest credit is typically a fixed rate, normally between 3% and 5%. When participants terminate employment, they are eligible to receive the vested portion of their TAB.
How are employer contributions calculated?
After the end of year, employee census data is provided to the actuary for the plan and they determine the contribution amounts and requirements. At Providence, we provide you with specific contribution options. We consult with you about your contribution options and help determine the best choice for you and the plan.
How are the 401(k) contributions calculated?
When working with Providence, each cash balance plan is custom designed, often to maximize tax-deferred contributions for the owners/partners while providing staff with a required contribution to satisfy IRS testing. Typically, that means a profit sharing contribution of 5% to 7.5% of pay for staff. After the end of each plan year Providence will calculate the optimized contribution amounts based on your objectives and the plan design. Our plan designs enable the maximum 401(k) amount to be contributed by the owners or partners. We use a 3% safe harbor contribution to pass the ADP Test.
What if the company is already making safe-harbor contributions?
The 3% of pay safe harbor non-elective contribution counts towards satisfying the staff profit sharing amount. However, employer matching contributions cannot be used to help satisfy this requirement.
Can the cash balance plan benefits be changed?
Yes, within certain limitations. Typically, contributions to owners/partners are written into the plan document as “the lesser of $Y or X% of compensation”. So, if compensation drops, the required contribution amount drops as well. This helps avoid the need to amend the plan. Cash balance plans can be amended to change the annual contribution levels at infrequent intervals. Usually, any reductions must be made before any eligible employee works 1,000 hours during a plan year. A cash balance plan can be frozen or terminated, but a contribution will probably still be required for the year. Your plan consultant can help with your questions about contribution levels and will explain the considerations and restrictions involved in amending the plan.
How does the cost of a cash balance plan compare with the cost of a 401(k) profit sharing?
It may appear that cash balance plans are more expensive to set up and maintain than 401(k) profit sharing plans. Cash balance plans are oftentimes more cost-effective. There are lower contribution limits imposed on 401(k) plans compared with the cost of plan administration, 401(k) plans are a more costly way to deliver retirement savings. Cash Balance plans allow employers significantly higher contributions and much larger tax deductions, thus making them more cost effective.
Does this plan design make financial sense for the employer?
If the “Allocation to Principals” shown on the plan illustration exceeds 75%, then the tax savings likely outweigh the cost of implementing and maintaining the plan.
Each company is unique and so are their retirement plan needs. Providence will meet with you, listen to your goals, questions, and concerns. Then we will design a plan that will best match your distinctive needs.
Please contact Nic Miller for a more information: nmiller@providence-retirement.com or 512-814-5752.