Quick Summary
A cash balance plan is a defined benefit plan that expresses each participant's benefit as a hypothetical account built from pay credits and interest credits. Because its limits are based on benefits rather than contributions, owners nearing retirement may be able to contribute substantially more than a 401(k) alone allows. The employer bears the investment risk, contributions are actuarially determined, and the plan is intended to be ongoing. Cash balance plans are often paired with a 401(k) and profit sharing plan.
For many business owners, a 401(k) with profit sharing provides plenty of room to save. For others, especially successful owners in their 50s and 60s who started saving seriously later in their careers, the annual limits on defined contribution plans feel tight.
A cash balance plan can change that math. It is also a bigger commitment than a 401(k), so it is worth understanding both sides before adopting one.
How a cash balance plan works
A cash balance plan is a type of defined benefit plan, but it looks more like a defined contribution plan to participants. Each participant has a hypothetical account that grows in two ways:
- Pay credits. Each year, the plan credits the account with a set amount, either a percentage of pay or a flat dollar amount, as defined in the plan document.
- Interest credits. The account also receives an interest credit, either a fixed rate or a rate tied to an index such as a Treasury rate.
When a participant leaves, the vested benefit is typically available as a lump sum that can be rolled to an IRA or another plan, or as an annuity.
Why owners consider them
Defined contribution plans limit how much can be contributed each year. Defined benefit plans, including cash balance plans, instead limit the benefit a participant can receive at retirement. Because older participants have fewer years to accumulate that benefit, the contribution needed to fund it is larger.
The result is that the allowable contribution for an owner rises with age. For owners in their 50s and 60s, a cash balance plan combined with a 401(k) and profit sharing plan can allow total tax-deductible contributions that are a multiple of what a 401(k) alone permits. Your actuary can illustrate the specific amounts for your situation.
The employer bears the investment risk
Participants' accounts grow by the interest credit regardless of how the plan's actual investments perform. If the investments earn more than the interest credit, future required contributions may go down. If they earn less, future required contributions go up.
Because of this, many cash balance plans invest relatively conservatively, aiming to track the interest crediting rate rather than maximize returns.
Contributions and flexibility
Each year, the plan's actuary determines a range of contributions, from a minimum required amount to a maximum deductible amount. That range provides some flexibility, but less than a profit sharing plan, where contributions can be skipped entirely in a lean year.
The commitment
The IRS expects a defined benefit plan to be a permanent arrangement, not a short-term tax strategy. A plan terminated within a few years without a valid business reason may draw scrutiny. Many practitioners suggest that employers be prepared to maintain the plan for at least several years.
Employees and nondiscrimination
A cash balance plan must cover employees and pass nondiscrimination testing, typically in combination with the company's 401(k) and profit sharing plan. Staff usually receive meaningful contributions, often through the defined contribution plan. Testing requirements for combined plans can be higher than for a profit sharing plan alone, so the cost of staff contributions should be modeled up front.
Costs and administration
Cash balance plans require more administration than a 401(k):
- An enrolled actuary to perform annual valuations and certify funding
- A Schedule SB filed with the plan's Form 5500
- Pension Benefit Guaranty Corporation premiums, if the plan is covered
Professional service employers, such as medical, legal, and accounting practices, with 25 or fewer active participants are generally exempt from PBGC coverage. Combined deduction limits also apply when an employer sponsors both a defined benefit and a defined contribution plan, so the actuary, TPA, and tax advisor should coordinate.
Who it fits
Cash balance plans tend to fit businesses with:
- Consistently high income that can support several years of contributions
- Owners age 45 and older who want to accelerate retirement savings
- A small staff relative to the number of owners or partners
- Owners already contributing the maximum to their 401(k) and profit sharing plan
Questions to ask before adopting
- Can the business commit to contributions for several years?
- How variable is cash flow?
- What will employees receive, and what will that cost?
- Who will serve as actuary and administrator, and how will plan assets be invested?
Want to see whether a cash balance plan could fit your business? Brian Williams, CPFA®, of Northshire Consulting LLC | Registered Investment Advisory Firm meets with business owners to review plan design options. Call 203-401-6062, email bwilliams@northshireconsulting.com, or visit northshireconsulting.com to schedule a plan review.
Frequently asked questions
Is a cash balance plan the same as a 401(k)?
No. A cash balance plan is a defined benefit plan. It is often paired with a 401(k), but it is a separate plan with its own rules.
Can contributions change from year to year?
Within the actuarial range, yes. Pay credit formulas can also be changed prospectively by plan amendment, subject to notice requirements.
What happens when a cash balance plan is terminated?
Participants become fully vested and benefits are distributed. Any funding shortfall must be made up by the employer, and surplus assets are subject to special tax rules.
This material is for educational purposes only and is not individualized investment, tax, or legal advice. Advisory services are offered through Northshire Consulting LLC | Registered Investment Advisory Firm.