Cash balance plans

In short

A friend of mine runs a design studio, and one evening on his porch he asked me why his accountant kept saying "cash balance" like it was a magic phrase. If you earn well and want to put away far more than a 401(k) allows, this guide may help. A cash balance plan is a kind of pension that the employer funds, and the law lets the employer deduct the cost. Each year the plan sets a target credit for each worker, and an actuary, who is a specialist in pension math, works out what the business must pay in. Older owners with steady profit often see the largest deduction. The business must keep paying every year, so a lean year can pinch. A written quote from an actuary and a plan administrator shows the real cost before any choice is made, and a tax professional can say how it fits one's own return.

The whole of it

What it is

I once watched a founder stare at a tax bill the way a man stares at a flooded basement. He had earned a good year, saved in his 401(k) up to the limit, and still owed a great deal. He wanted somewhere else to put money. If you are holding a business that earns a steady million or more, you may know that feeling.

A cash balance plan is a defined benefit plan. That means it promises each worker a stated sum at retirement, not a share of whatever the markets deliver. It looks like a pension, but each person has a paper account that grows by two credits each year. One is a pay credit, often a set dollar amount or a percent of pay. The other is an interest credit, set by the plan document. The account is only a bookkeeping figure. The employer holds one pooled fund and carries the investment risk.

The plan is a qualified retirement plan under the Internal Revenue Code and falls under ERISA, the federal law that protects workers in private plans. Its rules sit mainly in Internal Revenue Code sections 401(a) and 415, and the Department of Labor and the Pension Benefit Guaranty Corporation also play a part. The PBGC is a federal agency that insures many private pensions. Professional practices such as doctors and law firms are exempt from PBGC coverage when they are small enough, and a plan administrator can say whether that applies.

How it works

Think of it as a promise with a price tag. Say the plan credits an owner $150,000 a year until age 55. The employer must then fund enough each year to keep that promise on track. An enrolled actuary, a professional licensed to certify pension math, runs the numbers and signs off each year.

Here is the part folks like. The yearly contribution can run well past a 401(k) limit. The cap is set by the benefit the plan may pay, not by a small yearly deferral. The law limits the annual benefit under a defined benefit plan, and the IRS sets that cap each year. Older owners usually have fewer years to fund the promise, so the yearly deposit runs larger. That is why the plan often suits founders in their late forties and beyond.

The employer deducts the contribution, and the worker pays no tax until money comes out. At retirement or when the worker leaves, the account can often roll into an IRA. A rollover moves the money to another retirement account without a tax bill.

Many owners pair a cash balance plan with a 401(k) and a profit sharing plan. The pieces sit side by side. Each has its own limits and its own tests.

The plan also has tests. The law requires the plan not to favor the owners too much over the staff. When a firm has employees, the plan will likely require a pay credit for them as well. Often it is a modest percent of pay. That cost is real, and the sponsor pays it every year the plan runs.

The numbers, and where to find yours

I have learned that a number you cannot find is a number you cannot trust. So here is where each one lives.

The yearly limit on the benefit a defined benefit plan may pay is the current figure, which the official source publishes each year. The pay the plan may count for any one worker is the current figure, which the official source publishes each year. The ordinary 401(k) deferral limit is the current figure, which the official source publishes each year, which sits beside the plan and does not replace it. The IRS publishes these figures each year on its page of retirement plan limits, and the site fills in the verified figure with its date.

Your own numbers come from your actuary. The actuary asks for your age, your pay, the ages and pay of your staff, and the assumed interest rate. The plan document, the adoption agreement, and the annual actuarial valuation report hold the rest. The plan files a yearly Form 5500 with the government, and the Department of Labor makes those filings public. Read your own.

A worked example

Let me tell you about Marcus. He is 52 and owns a small engineering firm. The firm nets $1,000,000 a year before his own retirement savings. He already maxes his 401(k) and wants more room.

His actuary designs a cash balance plan with a pay credit for Marcus of $180,000 a year. The firm has four staff, and the plan gives each one a pay credit of 5 percent of pay. Their combined pay is $240,000. So 5 percent of $240,000 is $12,000 a year for the staff.

The firm's total cost is $180,000 plus $12,000, which is $192,000. Suppose the firm's combined tax rate is 35 percent. Then $192,000 times 0.35 is $67,200 in tax the firm avoids this year. The cost after tax is $192,000 minus $67,200, which is $124,800.

Now look at Marcus's account. Over ten years of $180,000 credits, the pay credits alone total 10 times $180,000, which is $1,800,000. Add interest credits, and the account would be larger. Say the plan credits 4 percent a year. The interest part is a smaller sum that builds each year, so the actuary would show the exact figure. I will not guess at it here.

Marcus liked the deduction. But he also saw the bill. Four staff and a $192,000 yearly cost is a promise. Good year or bad, the firm must fund it.

Where it goes wrong

A neighbor of mine learned this the hard way. His company had a rough year, and the plan still wanted its deposit. He had to find the cash. That is the first trouble. The contribution is not optional the way a 401(k) match can be. The business must fund the plan under minimum funding rules, and a missed deposit can bring an excise tax, which is a penalty tax.

The second trouble is a shaky profit line. If the business earns less, the owner may regret a high promise. Changing or ending a plan is possible, but it takes paperwork and sometimes a final funding.

The third is cost. An actuary, an administrator, and a yearly filing all carry fees. Those fees are real money, and they come every year. A written price shows the full cost up front.

The fourth is the staff. Required pay credits can run higher than a founder hoped, and the testing rules can force changes. Small trap. Big bill.

The fifth is the investment side. The plan promises the interest credit, but the fund may earn less. If it does, the employer makes up the gap. That is the cost of carrying the risk.

Last, the rules change. Limits move each year, and Congress sometimes alters the law. The current figures live on the IRS page, and they are worth checking before any decision.

Questions to answer before you leave this page

Have you asked an enrolled actuary for a written quote that shows your yearly cost, your staff cost, and your fees? Can your business carry that deposit in a slow year, not only a great one? How old are you, and how many years remain to fund the promise? What will the required credit for your employees cost, and have you added it to the total? Do you know which of your plans already exist, so the pieces fit together? And what would your tax professional say about how your own return would look? A man deserves a plan he can sleep on, and these questions are how he builds one.