Why have the number of Cash Balance Pension Plans tripled in the past decade? For many successful professional practices and business owners, Cash Balance Pension Plans can significantly reduce tax liabilities and can accelerate the growth of owner’s retirement assets far beyond other popular plans that are available. Because these pension plans enable participants to make larger yearly contributions, three to four times the dollar limit of other types of retirement plans such as 401(k)s, they have become increasingly popular with high-earning professionals and successful small business owners who want to accelerate their retirement savings. These plans also help to attract and retain talented employees.
Retirement plans come in two general types, defined contribution and defined benefit. A Cash Balance Pension Plan, also known as a Cash Balance Plan (CBP), is a defined benefit plan. Often referred to as a hybrid, the CBP has some characteristics of a defined contribution plan, where each participant’s benefit is stated in terms of an account balance.
Unlike a traditional defined benefit plan in which an individual who retires is promised a monthly benefit for life, a CBP defines a participant’s retirement benefits in terms of a hypothetical account balance. This balance is based on an annual “pay credit” (e.g. 4% of yearly compensation) and an ‘interest credit” (a fixed interest rate or index-linked variable rate).
A plan participant who begins retirement can choose an annuity based on the cash balance that has accumulated in the hypothetical account, or alternatively, under most plans, a lump sum can then be rolled over into an IRA or potentially into another employer retirement account. The employer alone directs the investments and bears the investment risk.
Participants can deduct the annual cash balance contributions, and the investments grow tax deferred. In addition, plan contributions can reduce state and local taxes. For businesses, the contributions are deductible expenses, potentially saving owners tens of thousands of dollars in annual taxes. Contributions to the CBP can be made up until the entity’s filing date including extensions.
In addition, for some professionals and business owners, a CBP deduction could result in eligibility for a Qualified Business Income (QBI) deduction. The QBI deduction is available to taxpayers who are structured as sole proprietorships, partnerships, or S Corporations. Taxpayers who qualify receive a 20% deduction of the income on their federal tax returns. Many professional businesses, such as physician practices, do not qualify for the QBI deduction unless their income is below certain levels ($220,050 for a single filer, and $440,100 for a married couple filing a joint return in 2022). A contribution to a CBP could help to reduce income below the thresholds required to qualify for the QBI deduction.
CBPs provide significant flexibility. Partners/shareholders can receive different contribution amounts. Owners can set “classes” and contribution levels for employee groups that provide flexibility in allocating retirement plan benefits.
CBPs are structured to target an allowable maximum income at retirement. This amount is indexed for inflation. Currently, owners and participants can build their personal pensions to the actuarial equivalent of a lifetime income of $245,000 at age 62 (which is derived from the maximum allowable pension balance of $3.1 million for 2022).
The CBP contribution amounts vary each year based largely on the age and income levels of participants, estimated years to retirement, and long-term investment experience. Older participants are allowed higher contributions because there is less time to compound and accumulate the maximum balance of $3.1 million prior to retirement. As an example, a 55 year-old may have a combined contribution limit of $289,500 when combining the cash balance limit with the $67,500 401(k) limit, whereas a 65 year-old would have a combined contribution limit of $362,500 after including the $67,500 401(k) limit.
The IRS specifies the maximum salary income that can be used in the annual contribution calculation: $305, 000 in 2022. Note that if reported salary or earnings are artificially low, this can limit annual contribution levels. Actuaries use income on Form W-2 for wage earners, line 14 self-employment income from a partnership k-1, and line 31 net profit or loss for businesses reporting on Schedule C of Form 1040 as primary sources for determining salaries or earnings.
Operating a CBP requires a custodian (who holds the plan’s assets), a recordkeeper (who tracks each participant’s balance in the plan), a third-party administrator (who ensure that all the Depart of Labor and ERISA rules, such as preparation of the annual actuarial report ,are followed), and an investment manager. In part because of the need for services of an actuary, these plans can be more costly to operate; however, plan assets are shielded from creditors in the event of a lawsuit or bankruptcy.
For CBPs with only a handful of participants, startup fixed costs can run $2,000 to $3,000, and ongoing annual costs can be about $3,000. Costs are incrementally higher for larger plans. There may also be Pension Benefit Guaranty premiums to pay, and the money manager will typically charge a fee equal to a percentage of assets.
A good starting point for any pension plan is providing a company census that includes owner and employee demographic information, including age and salary level, to the third-party administrator. The third-party administrator can then create a plan trust document that includes language to accommodate flexibility in needs or goals. The trust document is then provided to a custodian firm, most often a brokerage custodian that can set up the plan and hold plan assets. It is important to note that most CBPs are paired with 401(k) profit-sharing plans to maximize contributions and allow for plan funding flexibility.
A good candidate for a cash balance plan is a company that is profitable, has several hundred thousand dollars of salary or flow-through income, and cash flow available to make large ($100,000 or more) retirement contributions for more than five years. The company should also be willing to make limited contributions for nonowner employees (usually 5% to 7% of pay). These contributions are coordinated with the company’s safe-harbor 401(k) or profit sharing plan.
Many high-earning professionals and successful business owners got a late start in saving for retirement because of lengthy education requirements and initial careers as employees. The Cash Balance Plan can be an effective tool to accelerate the savings process.
These are some of the many reasons that the number of Cash Balance Pension Plans have tripled in the past decade.
Article submitted by Terri L. Marakos, CPA, CHBC.
Resource: “The rise of the cash balance pension plan.” Journal of Accountancy, January 2023
Resource information used with permission of the author, Grant S. Donaldson, MS, CPA, President, Tudor Financial
