Boost Retirement Savings with a Cash Balance Plan: How To

Are you worried about whether your retirement savings will be sufficient to live comfortably during your golden years? If so, it might be time to consider a cash balance plan. This unique retirement savings vehicle offers substantial tax advantages and allows you to maximize your contributions while building a sizable nest egg.

A cash balance plan is a type of defined benefit plan that combines elements of both traditional pension plans and 401(k)s. It provides a fixed investment return, guaranteeing growth regardless of market performance. Plus, contributions are tax-deductible, helping to lower your current taxable income.

The best part? You don't have to choose between a 401(k) and a cash balance plan – you can have both! By combining these retirement savings strategies, you can supercharge your savings and potentially retire earlier than you ever thought possible.

In this comprehensive guide, we'll walk you through the ins and outs of cash balance plans. From explaining how they work and providing examples of contributions to highlighting the tax advantages and potential pitfalls, you'll learn everything you need to know to make an informed decision about boosting your retirement savings with a cash balance plan. Don't miss out on this opportunity to secure a comfortable future!

What is a cash balance plan?

How does a cash balance plan work?

A cash balance plan is a type of retirement savings plan that falls under the category of defined benefit plans. Unlike defined contribution plans like 401(k)s, where the retirement benefit is based on the contributions and investment returns, a cash balance plan guarantees a fixed benefit amount at retirement.

In a cash balance plan, the employer contributes a certain percentage of the employee's salary each year, and these contributions, along with a specified interest rate, help grow the employee's cash balance account. The account balance increases annually, and at retirement, the employee can choose to receive either a lump sum or an annuity payment based on the accumulated cash balance.

This type of plan offers the best of both worlds, combining the security and predictability of a traditional pension plan with the flexibility and portability of a 401(k). It provides employees with a guaranteed retirement benefit, allowing them to better plan for their future.

Benefits of a cash balance plan

To understand how a cash balance plan works, let's consider an example. Imagine you work for Company A, which offers a cash balance plan as part of its retirement benefits package. Your employer contributes 5% of your salary to your cash balance account each year, and this contribution is based on your annual salary.

Let's say your annual salary is $100,000. In this case, your employer would contribute $5,000 to your cash balance account. Over time, as your salary increases, the employer's contribution also increases, helping to grow your retirement savings faster.

The cash balance account grows at a specified interest rate, often tied to the performance of a benchmark such as the 30-year Treasury bond rate. This ensures that your account balance continues to increase, regardless of market conditions. The interest credits are typically posted annually, further boosting your retirement savings.

At retirement, you have the option to receive your cash balance account as a lump sum or as an annuity payment. The lump sum option provides you with a one-time payment, which you can use to fund your retirement or invest elsewhere. The annuity option, on the other hand, guarantees a stream of income for the rest of your life, providing financial security throughout your retirement years.

Cash balance plan vs. traditional pension plan

Cash balance plans offer several advantages over other retirement savings options. Let's take a closer look at some of the key benefits:

1. Tax Advantages

One of the biggest advantages of a cash balance plan is the tax benefits it offers. Contributions made by the employer are tax-deductible, meaning they reduce the company's taxable income. This can result in significant tax savings for the employer, making cash balance plans an attractive option for businesses of all sizes.

For employees, contributions to a cash balance plan are also tax-deferred. This means that the money contributed to the plan grows tax-free until retirement. At that point, when you start receiving distributions, the amount will be taxed as ordinary income. However, since most retirees have a lower income in retirement, they often find themselves in a lower tax bracket, resulting in overall tax savings.

2. Higher Contribution Limits

Cash balance plans allow for higher contribution limits compared to other retirement plans like 401(k)s and IRAs. The contribution limit is calculated based on a combination of factors, including the employee's age, salary, and years of service. In general, the older you are and the higher your salary, the more you can contribute to your cash balance plan.

This higher contribution limit can be particularly advantageous for high-income earners who want to maximize their retirement savings. It allows them to save a larger percentage of their income and potentially accumulate a significant nest egg over time.

3. Guaranteed Growth

Unlike defined contribution plans where the value of the account fluctuates with market performance, cash balance plans offer guaranteed growth. The employer's contributions, along with the specified interest rate, ensure that your cash balance account grows each year, regardless of how the financial markets are performing.

This stability and predictability provide peace of mind, knowing that your retirement savings will continue to grow steadily over time. It shields you from the volatility of the stock market and reduces the risk of losing a substantial portion of your savings due to market downturns.

4. Portable and Flexible

Another advantage of cash balance plans is their portability and flexibility. If you change jobs, you can take your cash balance account with you, either by rolling it over into an individual retirement account (IRA) or by transferring it to your new employer's cash balance plan, if they offer one.

This portability ensures that your retirement savings remain intact and continue to grow, regardless of where your career takes you. It also provides flexibility in terms of how you choose to receive your retirement benefit at retirement. Whether you prefer a lump sum or an annuity payment, a cash balance plan allows you to customize your retirement income to suit your individual needs.

Eligibility and contribution limits for cash balance plans

While cash balance plans share similarities with traditional pension plans, there are some key differences to be aware of. Traditional pension plans provide a retirement benefit based on a formula that takes into account factors such as years of service and final average salary. The benefit is usually paid out in the form of a monthly annuity, providing a steady stream of income throughout retirement.

In contrast, cash balance plans offer a more individualized approach to retirement savings. The benefit is based on the contributions made by the employer, along with the specified interest rate. Employees have the flexibility to choose between a lump sum or an annuity payment at retirement, depending on their personal preferences and financial needs.

Another difference is the way the benefits are funded. Traditional pension plans are funded solely by the employer, who assumes the investment risk and the responsibility for ensuring that there are sufficient funds to pay out the promised benefits. In cash balance plans, the employer's contributions are invested, and the investment risk is shared between the employer and the employee.

How to set up a cash balance plan for your business

To be eligible for a cash balance plan, you typically need to work for a company that offers this type of retirement benefit. Cash balance plans are most commonly found in businesses with a small number of employees or professional practices such as medical, legal, or consulting firms.

The contribution limits for cash balance plans are determined by the IRS and are subject to annual adjustments. The limits are calculated based on a combination of factors, including the employee's age, salary, and years of service. The older you are and the higher your salary, the more you can contribute to your cash balance plan.

For example, in 2021, the maximum annual contribution limit for a cash balance plan is $230,000. This amount can be a combination of the employer's contribution and the employee's contribution, if allowed by the plan. However, it's important to note that the actual contribution limit for each individual may vary based on their specific circumstances.

Tax advantages of a cash balance plan

Setting up a cash balance plan for your business involves several steps. Here's a general overview of the process:

1. Consult with a Retirement Plan Professional: Start by consulting with a retirement plan professional who specializes in cash balance plans. They can assess your business's eligibility and help you determine if a cash balance plan is the right fit for your company.

2. Design the Plan: Work with your retirement plan professional to design a cash balance plan that meets the needs of your business and employees. This includes determining the contribution formula, vesting schedule, and other plan provisions.

3. Submit the Plan for Approval: Once the plan is designed, it needs to be submitted to the IRS for approval. This ensures that the plan meets all the necessary legal and regulatory requirements.

4. Communicate the Plan to Employees: After the plan is approved, communicate the details of the cash balance plan to your employees. Provide them with the necessary information and resources to understand how the plan works and how it can benefit them.

5. Implement and Administer the Plan: Once the plan is in place, you'll need to work with a third-party administrator to handle the day-to-day administration of the cash balance plan. This includes tasks such as calculating contributions, monitoring compliance, and providing annual statements to participants.

By following these steps, you can establish a cash balance plan that helps your employees save for retirement while providing tax advantages for your business.

Investment options for a cash balance plan

As mentioned earlier, cash balance plans offer significant tax advantages for both employers and employees. Let's take a closer look at some of these tax benefits:

1. Employer Tax Deductions

Employer contributions to a cash balance plan are tax-deductible, meaning they can be deducted from the company's taxable income. This can result in significant tax savings for businesses, especially those with high profits.

By contributing to a cash balance plan, employers can reduce their tax liability while simultaneously providing a valuable retirement benefit to their employees. It's a win-win situation that can help businesses attract and retain top talent.

2. Employee Tax Deferral

For employees, contributions made to a cash balance plan are tax-deferred. This means that the money contributed to the plan grows tax-free until retirement. Since contributions are made on a pre-tax basis, they lower the employee's current taxable income.

This tax deferral allows employees to save more for retirement, as they can contribute a larger amount without reducing their take-home pay significantly. It also provides an opportunity for tax diversification, as retirees can choose to receive distributions from their cash balance plan alongside other taxable and tax-free income sources.

3. Tax-Free Growth

Another tax advantage of cash balance plans is the tax-free growth of the account balance. As contributions are made and the interest credits are applied, the cash balance account grows tax-free. This allows the retirement savings to compound over time, maximizing the potential for wealth accumulation.

Since the growth of the account is not subject to annual taxation, the retirement savings can grow faster compared to taxable investment accounts. This can make a significant difference in the long run, helping employees build a larger nest egg for retirement.

4. Tax Savings in Retirement

While contributions to a cash balance plan are tax-deferred, the distributions received in retirement are subject to ordinary income tax. However, since most retirees have a lower income in retirement compared to their working years, they often find themselves in a lower tax bracket.

This lower tax bracket, combined with the ability to control the timing and amount of distributions, can result in significant tax savings. By carefully planning the withdrawals from their cash balance plan, retirees can minimize their tax liability and maximize their after-tax income.

Risks and considerations of a cash balance plan

Cash balance plans offer a range of investment options for participants to choose from. These options vary depending on the plan provider and the investment platform used. Here are some common investment options you may find in a cash balance plan:

1. Fixed-Income Investments

Fixed-income investments, such as bonds and bond funds, are a popular choice for cash balance plans. These investments provide a steady income stream and are considered less volatile compared to stocks. They can help preserve the principal and provide stability to the cash balance account.

Fixed-income investments are particularly suitable for participants who are close to retirement or have a lower risk tolerance. They offer a reliable source of income and help protect the retirement savings from market downturns.

2. Equity Investments

Equity investments, such as stocks and stock funds, provide the potential for higher returns but come with increased risk. These investments are subject to market fluctuations and can experience significant volatility.

Equity investments are typically suitable for participants with a longer investment horizon and a higher risk tolerance. They offer the potential for growth and can help the cash balance account keep pace with inflation over time.

3. Target-Date Funds

Target-date funds are a popular investment option for cash balance plans. These funds automatically adjust the asset allocation based on the participant's expected retirement date. They start with a more aggressive allocation in the early years and gradually shift towards a more conservative allocation as retirement approaches.

Target-date funds provide a convenient and hands-off approach to investing. Participants simply choose the fund with the target retirement date closest to their own and let the fund manager handle the asset allocation and rebalancing.

4. Customized Investment Portfolios

Some cash balance plans also offer the option to create customized investment portfolios. Participants can choose from a selection of mutual funds, exchange-traded funds (ETFs), and other investment vehicles to build a portfolio that aligns with their individual investment goals and risk tolerance.

Customized investment portfolios provide flexibility and allow participants to tailor their investments to their specific needs. They offer the opportunity to diversify across different asset classes and investment styles, potentially enhancing the risk-adjusted return of the cash balance account.

Conclusion: Is a cash balance plan right for you?

Ultimately, the decision to participate in a cash balance plan should be based on your unique financial circumstances and goals. It's important to have a comprehensive understanding of the plan, seek professional advice when needed, and make a decision that aligns with your long-term financial well-being.

Boost Your Retirement Savings with a Cash Balance Plan: Here's How