When it comes to retirement planning, most people think 401(k)s, IRAs, etc.
But there's one option that is extremely beneficial for high income business owners that is not thought about enough... introducing cash balance plans.
Cash balance plans are an increasingly popular option for business owners and high-income earners looking to maximize their retirement savings. These plans offer huge tax advantages and higher contribution limits compared to traditional retirement accounts. They are most often paired with a 401(k) or solo 401(k).
In this post, we'll explore what cash balance plans are, their contribution limits, and key considerations to keep in mind.
What is a Cash Balance Plan?
A cash balance plan is a type of defined benefit pension plan that combines features of both traditional defined benefit plans and defined contribution plans like 401(k)s. In a cash balance plan, each participant has an individual account that is invested. But you need it to be conservative. Since it is targeting a future value, you will have a hurdle rate like 3%, 4%, 5%, etc. If your account grows more than that, you will be able to put in less next year. If is grows less, you will be able to put in more next year.
How Cash Balance Plans Work
- Employer Contributions: The employer makes annual contributions to each participant's account. These contributions are typically based on a percentage of the participant's salary or a flat dollar amount.
- Interest Credits: Each participant's account earns interest credits at a predetermined rate, which is usually tied to a benchmark such as the yield on 30-year Treasury bonds. This rate is guaranteed and independent of the plan's investment performance. They base their benefits on a hypothetical account balance, increased with principal credits, and adjusted with interest credits. Interest credits cannot exceed a market rate of return
- Vesting: Participants typically become vested in their accounts over a period of time, meaning they earn the right to the benefits accrued in their accounts.
- Distribution Options: Upon retirement or leaving the company, participants can choose to take their account balance as a lump sum, convert it into an annuity, or often roll to an IRA. Then do Roth conversions in early retirement.
Contribution Limits
One of the most attractive features of cash balance plans is their high contribution limits, which are age-dependent. The older the participant, the higher the contribution limit, allowing for accelerated retirement savings. Here are the contribution limits for 2024:
- Under 40: Up to $100,000
- Ages 40-49: Up to $150,000
- Ages 50-54: Up to $200,000
- Ages 55-59: Up to $250,000
- Ages 60 and above: Up to $300,000
These limits are significantly higher than those for traditional 401(k) plans, making cash balance plans an excellent option for high-income earners looking to boost their retirement savings. Like I said above, most will pair this on top of another retirement plan and get a ton of deferral.
Key Considerations
While cash balance plans offer numerous benefits, there are several factors to consider before implementing one:
- Consistent Cash Flow: Cash balance plans require annual contributions, making them best suited for businesses with consistent cash flow and profitability. Inconsistent earnings can make it challenging to meet the required contributions. You sign up for a period of time for this and have to do it each year.
- Administrative Complexity: These plans are more complex to administer than traditional 401(k) plans. They require actuarial calculations, annual valuations, and compliance with various regulations. It's essential to work with experienced professionals to manage the plan effectively.
- Cost: The administrative and actuarial costs associated with cash balance plans can be higher than those for other retirement plans. Ensure that your business can absorb these costs before proceeding.
- Employee Participation: While cash balance plans can be designed to benefit key executives and highly compensated employees, they must also provide benefits to rank-and-file employees. The plan must pass non-discrimination tests to ensure it doesn't disproportionately favor highly compensated employees.
- Plan Amendments: Changes to contribution levels and plan design require formal amendments. While contributions can be adjusted, it's essential to plan ahead and make changes within the allowed time frames to avoid penalties.
Advantages of Cash Balance Plans
- High Contribution Limits: Allows for substantial retirement savings, especially for older participants.
- Tax Benefits: Employer contributions are tax-deductible, reducing the business's taxable income. Additionally, the plan's assets grow tax-deferred. This allows for Roth conversions down the line and lowering your lifetime effective tax rate.
- Predictable Growth: Guaranteed interest credits provide predictable growth, making it easier to plan for retirement.
- Flexibility in Retirement: Participants can choose between a lump sum or annuity, offering flexibility in how they receive their benefits.
Cash balance plans are a powerful tool for business owners and high-income earners looking to maximize their retirement savings. With high contribution limits, significant tax benefits, and predictable growth, these plans can play a crucial role in a comprehensive retirement strategy. However, they come with administrative complexities and costs, making it essential to work with experienced professionals to ensure the plan's success.
