What is a Cash Balance Plan?

March 3, 2020

A cash balance plan is a mix between a traditional defined benefit pension plan and a defined contribution plan (such as a 401(k). A cash plan allows workers to have the option of a lifetime annuity. In my most cases, employers will contribute a set portion of a participant’s salary to the plan each year (a “pay credit”; usually equal to between 5% and 8% annually), and the participant’s account will also be credited with an interest credit each year. For each year that an employee earns benefits with a company, that employee accrues benefits according to the following formula that an annual benefit equals (wage x pay credit rate) plus (account balance x interest credit rate). What does the model Cash Balance Plan Candidate look like? Cash balance plans make sense and are popular among business owners as well as professionals who have not been able to collect sufficient retirement income savings early in their professional career. Because a cash balance plan offerings lower adjusted gross income, these clients (who often have higher income) can also benefit from reduced tax liability on several fronts through contributing to a cash balance plan. What is the difference between a 401k and a Cash Balance Plan? With a 401(k), the money that the employee will have in retirement is not “distinct.” Instead, the employee’s retirement benefits rely on the performance of the market and of the funds that hold the 401(k) contributions. The employee risks that a market downturn can potentially get rid of their 401(k). With a cash balance plan, the amount of money an employee can expect in retirement is “distinct.” That is why it is called a Defined Benefit plan. The employer, (instead of the employee, like in a 401k plan), bears the risk of market fluctuations. By advantage of their Defined Benefit status, cash balance plans are insured and must offer the option of a lifetime annuity, neither of which holds true for 401(k)s. For small to medium business owners, using a cash balance plan to potentially grow the rate of retirement savings later in one’s career can prove invaluable—if the cost-benefit analysis discussed above weighs in favor of adopting the cash balance plan.   This information was developed as a general guide to educate plan sponsors, but is not intended as authoritative guidance or tax or legal advice. Each plan has unique requirements, and you should consult your attorney or tax advisor for guidance on your specific situation. In no way does advisor assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations.