Take another look at cash balance plans

Another look at cash balance plansCompensation and Benefits Bulletin
Your firm’s partners or owners may need to accumulate funds for retirement, perhaps beyond the 401(k)/profit-sharing annual contribution limit. Cash balance plans can be designed to significantly accumulate retirement benefits for owners/partners. In many cases, annual contributions for older individuals can exceed $200,000, in addition to maximum contributions by an individual and company in a 401(k)/profit-sharing plan of $53,000 ($59,000 for participants at least age 50). Benefit levels can also vary by individual and be weighted in favor of partners/owners.

Your company may need a reasonably priced benefit program for all employees to separate it from competitors’ programs. Cash balance plans can be designed as a benefit for all employees. An example would be a plan that credits 3% of annual compensation to each individual’s account yearly and credits 4% annual interest. Because the plan is a defined benefit plan, required contributions are calculated actuarially, but, depending on demographic experience and asset returns, the long-term costs could be in the range of 3% to 5% of payroll.

Cash balance plans have become the predominant defined benefit plan. The benefits are relatively easy for the plan participant to understand because accrued benefits are defined in terms of an account balance, similar to a savings or profit-sharing account. In addition, the lump sum payable upon a participant’s termination is simply the nominal account value, which is not related to current interest rates.  

The plan’s benefit formula is defined in the form of a nominal account to which employer contributions and interest are added. (There are actually no individual asset accounts.) At retirement, the participant may elect to take a lump sum distribution even though a joint and survivor annuity is required to be the default form of payment (that is, an annuity paid out over the lifetime of the individual and his or her spouse).

Minimum contributions, annual actuarial valuations, filings and notices are requirements, as for any qualified defined benefit plan. Specific plan design features and prudent asset management can significantly lessen contribution volatility. Employer contributions are tax deductible, and participants are taxed when they receive benefits, as with any qualified plan.

Today’s most popular cash balance plan design uses general nondiscrimination testing to combine the benefits payable under a cash balance plan with a 401(k)/profit-sharing plan. This plan design allows maximum weighting of benefits to designated individuals, which has caused many professional partnerships and privately held companies to choose this plan design.  

Contributing to the recent popularity are recent regulations that have clarified some outstanding issues and made an interest crediting rate equal to the actual return on assets an attractive option. These cash balance plans are referred to by several names including “actual rate of return plans” and “market-based cash balance plans.” Benefits can increase or decrease within limits based on the actual return of plan assets. This design significantly lessens the investment risk to the employer and also the volatility of contribution requirements.

Whether your firm is a partnership, a small owner-dominated company or a large company, a cash balance plan may be the benefit program that best suits your needs.

Ray Berry
+1 312 602 8333

Tax professional standards statement
This document supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the subject of this document, we encourage you to contact us or an independent tax adviser to discuss the potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this document may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this document is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.