Pension plans are becoming harder to find when it comes to retirement planning. These plans typically cost more for employers, and the employee is more responsible for contributing to retirement savings.
Cash balance plans are defined benefit plans that allow employers to place a certain percentage of an employee’s compensation into their account each year.
Some employers offer a cash balance plan and a 401(k), which can help grow your retirement account balances. So, what exactly is a cash balance plan, and how does it work? We will explain all the details that you need to know.
What Is A Cash Balance Plan?
A cash balance plan is a defined benefit plan that the IRS recognizes as a qualified retirement plan. This means that it offers all the legal protections of ERISA.
- These are technically defined benefit plans, although they function similarly to a defined contribution plan.
- Each year, the employer contributes a specified amount to the employee’s account balance along with an interest credit. These annual contributions are usually a percentage of the employee’s overall compensation—6% is typical.
- Unlike traditional defined benefit plans, such as a traditional pension plan, the cash balance plan is maintained individually instead of at the company level.
- The employer must maintain professional management of these accounts and have an actuary certify each year that the accounts are properly funded.
Since employers bear the risk of investments, the IRS needs to ensure that employers fund the accounts with enough money to cover current liabilities.
Upon retirement, the employee can choose to receive an annuity or lump sum payment. The funds can also be rolled over into an IRA or other retirement account.
KEY TAKEAWAYS
- Upon retirement a cash balance plan can provide a defined benefit in the form of an annuity or a lump sum based on the account balance.
- A cash balance plan is different from a traditional pension plan, because the plan is maintained at the individual employee level instead of at the company level.
- These plans are often se up to benefit executives and other highly paid employees, with contributions limits as much as $341,000.
How Cash Balance Pension Plans Work
Each year, the employer contributes to the plan through a pay credit and an interest credit.
- The pay credit is typically expressed as a percentage of the employee’s compensation—for example, 6% of their salary.
- The interest credit may be either a fixed rate or a variable rate tied to the U.S. Treasury yield or something similar.
These credits are deposited into the account yearly, and a cash balance accrues as the account grows.
The plan documents will explain how your specific plan works and provide information on the plan’s assets and investment options.
- The employer bears all the investment risk, and they have agreed to provide certain retirement benefits when each employee reaches retirement age, regardless of the investment performance.
- Each participant’s account is maintained individually, and they may choose to receive either an annuity or lump sum at retirement.
Cash balance plans have extremely high contribution limits, and cash balance contributions offer the employer big tax savings. Unlike a profit-sharing plan, employer contributions to the plan must be made every year according to the plan documents. There are no employee contributions to a cash balance plan.
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Eligibility & Contribution Limits
Eligibility to start a cash balance plan is wide open, and nearly any company, from large corporations to small businesses, can start one.
These plans are often set up to benefit executives and other highly paid employees, but a company can decide to have any range of eligible employees. Business owners frequently seek out these plans because of their high contribution limits.
People age 70 and older can put away $341,000 annually into a cash balance plan. Compare that to the tax deductions and contribution limits associated with a traditional 401(k).
The traditional 401(k) allows for a maximum contribution of $76,500 in 2024, including employee and employer contributions.
You can easily see how having both plans can lead to fantastic tax deferral strategies and quick retirement savings growth. While there are technically no catch-up contributions with a cash balance plan, the tax-deferred contribution limits grow as your age increases.
So, in a way, the plan design rules allow for catch-up contributions later in life. The specific dollar amount depends on your age and your employer’s plan.
TIP
A cash balance plan can be a great way to save a significant amount quickly for retirement. If you opt for the lump sum distribution of your cash balance, you can usually roll that over into an IRA or other investment account.
Cash Balance Pension Plan vs Traditional 401(k)
While these plans have some similarities, there are also a few significant differences regarding pension vs 401(k).
First, a 401(k) usually relies on both employee and employer contributions. While most employers offer matching contributions, your 401(k) balance will usually remain at zero unless you also contribute some of your own money.
- When you begin contributing funds to the account, you also decide on the investment allocation. If your investments do well, then you see the benefit. However, if your investments perform poorly, then your account balance suffers as a result.
- The contributions you make into your 401(k) are tax deductible in the current year, and you will pay regular income taxes on those funds when you withdraw at retirement age.
With a cash balance pension plan, the employer usually makes all the contributions and bears all the investment risk for the employee’s benefit.
- This means that the employer promises a certain benefit, and they must make up the difference for any poor investment performance.
- Cash balance pension plans usually provide a defined benefit in the form of an annuity for annual cash flow or a lump sum based on the account balance.
In this respect, the plan functions more like a defined contribution plan because the balance is based on your individual account.
Differences Between Cash Balance Plan And Traditional Pension
Many people wonder, “How does a pension work?” Regarding cash balance versus traditional pension plans, these two plans are pretty similar, although some differences exist.
- First, a traditional pension plan is managed more at the company level. The benefit you will receive at retirement is defined in the plan documents and does not have a balance in an individual account.
- However, with a cash balance plan, you get pay crediting and interest crediting each year into your account. While it is a defined benefit plan, the benefit available to you upon retirement is based on the balance in the account at that time.
Traditional pension plans typically do not offer a lump sum option. Instead, they usually provide defined benefits through monthly annuity payments upon retirement.
- However, the cash balance plan usually offers a lump sum based on your account balance. If you need help deciding whether an annuity or lump sum payment suits you, you should talk to a financial advisor.
- If you opt for the lump sum, you can usually roll that over into an IRA or other retirement account.
Both plans are qualified plans, and ERISA and other laws protect the participants. The plan sponsor is also required to provide an annual funding notice for both types of plans each year so that participants and regulators can examine the plan’s overall health.
With both types of plans, the employer bears the investment risk, although the traditional pension is managed at the company level instead of the individual account level.
The Bottom Line
Cash balance pension plans are a great benefit that some companies offer to their employees. These plans provide an excellent way for the employer to help employees save for retirement.
They also offer employers some great tax benefits from the IRS. These are defined benefit plans, although they function like defined contribution plans in many ways.
Upon retirement, employees can usually choose different methods for receiving the balance in their accounts. Business owners prefer these plans for their highly high contribution limits.
If you can participate in a cash balance plan, you should take advantage of it!
Frequently Asked Questions
You can usually only take money out of these plans upon retirement or if you leave the company. If you leave the company and decide to cash out your pension plan, you might be stuck paying some early withdrawal penalties.
Most cash balance plans do not allow for loans or borrowing from them. However, at retirement, you can usually withdraw the entire balance as a lump sum or receive annuity payments based on the amount in your account.
If you are an employee, your employer will set everything up for you. You should contact your HR department to enroll in the plan.
For employers, setting up a cash balance plan is not extremely difficult. You must find an administrator and draft all the plan documents. Next, you will need to make the initial contributions to the plan and then establish a monitoring plan to ensure that the plan is being managed appropriately.
Your third-party administrator should be able to help you get things set up and running smoothly.
Contributions are usually made to the plan each year. This includes both the compensation contribution and the interest contribution.
The contributions might be made at the end of the calendar year or near the end of your company’s fiscal year. Typically, plan contributions are made at the end of the calendar year.
It varies according to your plan documents. Some plans provide complete vesting after as few as six months of employment, while others require three years.
It would help if you referred to your plan’s documentation to determine the specific vesting rules associated with your cash balance plan.
When you leave your employer, you are entitled to receive the vested balance in your account.
Your employer contributes to a cash balance plan, which is a benefit provided to employees to help them save for retirement. No employee contributions are required.
The employer contributes both the pay credit and the interest credit into your account each year. In some years, they might have to make an additional contribution to help make up for poor investment performance.
The actuary’s annual report details the plan’s health and helps the employer decide whether additional contributions are necessary.
You can find a Social Security Administration office near you by using our SSA office locator and searching for your closest location.
