While most business owners may be familiar with the 401(k) plan, much fewer have heard of the cash balance plan. This is despite the growing popularity of these plans since the Pension Protection Act of 2006. To be perfectly honest, however, cash balance plans are somewhat difficult to wrap your brain around given their “hybrid” nature; that is, cash balance plans look like defined contribution plans (like a 401(k)) but are actually a defined benefit plan (like a pension).
Kravitz, a cash balance plan design firm, has a straightforward description:
(Source: Kravitz)
So how do these plans work from the participant perspective? As it turns out, the Department of Labor has a pretty good consumer bulletin on cash balance plans:
(Source: Department of Labor)
The value to the business owner — aside from the tax benefits — is the ability to contribute a much larger amount to the cash balance plan as compared to a 401(k). For example, a person born in 1970 could contribute up to $111,322 (based on 2016 limits). In addition, this person could contribute an additional $18,000 to the 401(k) plan for a total retirement savings of $129,322. This is quite an improvement over the maximum all-in contribution (from employee and employer) of $53,000 for a standalone 401(k).
A consistent record of positive cash flow and profits is a prerequisite, however, since the company is obligated to fund the annual contributions. Additionally, a quick-and-dirty rule of thumb is that if 70% of the company contributions going into the plan is for key stakeholders (e.g., owners), the tax savings for those key personnel makes the cost of funding and administering the cash balance plan worthwhile.
Cash balance plans should be used alongside 401(k) plans, not in place of them, and are more expensive to setup and manage. Business owners should talk to their financial advisors about the cost and benefit of these plans, especially within the context of succession or exit planning.
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