Pension plans are becoming harder to find these days when it comes to retirement planning. These plans typically cost more for employers, and more responsibility is being placed on the employee to contribute to retirement savings. Cash balance plans are a form of defined benefit plan that allows employers to place a certain percentage of an employee’s compensation into their account each year. Some employers offer both a cash balance plan and a 401k, and this combination can really 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 type of defined benefit plan that is recognized by the IRS as a qualified retirement plan. This means that it offers all the legal protections of ERISA. These plans are technically defined benefit plans, although they function similarly to a defined contribution plan. Each year, the employer contributes a specified amount into the employee’s account balance along with an interest credit. These annual contributions are usually a percentage of the employee’s overall compensation – somewhere in the range of 6% is typical.
Unlike traditional defined benefit plans like a traditional pension plan, the cash balance plan is maintained on an individual basis instead of at the company level. The employer must maintain professional management of these accounts, and they must have an actuary certify each year that the accounts are properly funded. Since the employer bears the risk of investments, the IRS needs to ensure that employers are funding the accounts with enough money to cover the current liabilities. Upon retirement, the employee can choose to receive an annuity or lump sum payment. These funds can also be rolled over into an IRA or other type of retirement account.
How Cash Balance Pension Plans Work
Each year, the employer makes a contribution to the plan in the form of 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 that is tied to the U.S. Treasury yield or something similar. These credits go into the account each year, and a cash balance accrues in the account as it grows.
The plan documents will spell out the details of how your specific plan works. These documents will show the details about the plan assets and the plan’s 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 some big tax savings to the employer. Unlike a profit sharing plan, the employer contributions into the plan must be made every year according to the plan documents. There are no employee contributions into a cash balance plan.
Eligibility & Contribution Limits
Eligibility to start a cash balance plan is wide open, and nearly any company can start one from large corporations to small businesses. 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 often seek out these plans because of their very high contribution limits.
In fact, people age 70 and older can put away over $300,000 per year 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 in 2021 of $64,500 between both employee and employer contributions. You can easily see how having both of these plans can lead to some amazing 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 do allow for catch up contributions later in life. The specific dollar amount depends on your age and your employer’s plan.
Cash Balance Pension Plan VS Traditional 401(k)
While there are some similarities between these plans, there are also a few major differences as well when it comes to a pension vs 401k. First, a 401(k) usually relies on both employee and employer contributions. While most employers offer matching contributions, your 401k balance will usually remain at zero unless you contribute some of your own money as well. 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 that you make into your 401k are tax deductible in the current year, and you will pay regular income taxes on those funds when you make withdrawals at retirement age.
With a cash balance pension plan, the employer usually makes all the contributions. In addition, the employer 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?” When it comes to cash balance versus traditional pension plans, these two plans are quite similar although there are some distinct differences. First, a traditional pension plan is managed more at the company level. The benefit that you will receive at retirement is defined in the plan documents, and do 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 own account. While it is a defined benefit plan, the exact benefit available to you upon retirement is based on the balance in the account at that time.
Traditional pension plans typically offer no lump sum option. These plans usually offer defined benefits in the form of 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 is right for you, then 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 the plan participants are protected by ERISA and other laws. The plan sponsor is also required to provide an annual funding notice for both types of plans each plan year so that participants and regulators can examine the overall health of the plan. The employer bears the investment risk with both types of plans, although the traditional pension is managed at the company level instead of the individual account level.
The Bottom Line
Cash balance pension plans are great benefits that some companies offer to their employees. These plans provide a great way for the employer to help employees save for retirement. They also offer some great tax benefits from the IRS to the employer. These plans are defined benefit plans, although they function much like defined contribution plans in many ways. Upon retirement, an employee can usually choose different methods for receiving the balance in their account. Business owners prefer these plans for their extremely high contribution limits. If you are eligible to participate in a cash balance plan, you should absolutely take advantage of it!
Frequently Asked Questions
Can you take money out of a cash balance plan?
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 of these plan types do not allow for loans or borrowing from them. However, at retirement, you can usually choose to withdraw the entire balance as a lump sum or receive annuity payments based on the amount in your account.
How do you set up a cash balance plan?
If you are an employee, your employer will handle getting everything set 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 will need to find an administrator for your plan and draft all the plan documents. You should 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.
How often are contributions made to a cash balance plan?
Usually contributions are 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.
What are the vesting rules for a cash balance plan?
It varies according to your plan documents. Some plans provide complete vesting after as few as 6 months of employment while others require 3 years of employment. You should refer 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.
Who contributes to a cash balance plan?
Your employer contributes to a cash balance plan. This is a benefit provided to employees to help them save for retirement. No employee contributions are required when it comes to a cash balance plan. 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 annual report from the actuary will detail the health of the plan and help the employer decide whether additional contributions are necessary.