Understanding Cash Balance Plans: A Guide for Employers and Employees

 

Cash balance plans are a type of defined benefit retirement plan that combines features of both traditional pension plans and 401(k) plans. They provide employees with a promised retirement benefit, while offering employers a structured contribution framework with potential tax advantages.

How Cash Balance Plans Work

Unlike traditional pension plans, which define retirement benefits based on years of service and final salary, cash balance plans credit employees' accounts with a percentage of their salary each year, plus interest. These contributions and interest credits grow over time, similar to a 401(k) plan, but with less investment risk for the employee.

Each participant’s account in a cash balance plan receives:

• Pay Credit: A percentage of annual salary contributed by the employer.

• Interest Credit: A fixed or variable rate, determined by the plan.

At retirement or upon leaving the company, employees can take their accrued balance as a lump sum or convert it into an annuity for lifetime income.

Benefits of Cash Balance Plans

For employers:

• Tax Advantages: Contributions are tax-deductible, reducing taxable income.

• Retirement Security: Helps attract and retain employees by providing predictable retirement benefits.

• Higher Contribution Limits: Allows higher contribution limits than 401(k) plans, making it ideal for business owners and high-income earners.

For employees:

• Predictable Growth: Accounts grow at a predetermined interest rate, reducing investment risk.

• Portability: Employees can roll over their balance into an IRA or another employer’s plan.

• Guaranteed Benefits: Unlike 401(k)s, cash balance plans provide a defined benefit that is not subject to market fluctuations.

Considerations and Risks

While cash balance plans offer significant advantages, they also come with complexities:

• Employer Commitment: Employers must consistently fund the plan, even in economic downturns.

• Administrative Costs: These plans require actuarial calculations and compliance with regulatory standards, increasing administrative expenses.

• Employee Understanding: Employees may need guidance to fully grasp how the plan differs from traditional 401(k) options.

Who Should Consider a Cash Balance Plan?

Cash balance plans are particularly beneficial for:

• Business owners seeking higher tax-deferred retirement contributions.

• Companies looking to offer competitive retirement benefits.

• Professionals with high earnings, such as doctors, lawyers, and consultants, who want to accelerate retirement savings.

Conclusion

Cash balance plans serve as a powerful tool for both employers and employees, combining the security of a pension with the flexibility of a defined contribution plan. While they require careful planning and administration, their tax benefits, predictable growth, and portability make them an attractive option for many businesses and professionals looking to enhance retirement savings strategies.