The rise of the cash balance pension plan

Many successful business owners and professionals begin their high-earning years belatedly because of lengthy educational requirements and initial careers as employees. Financial planning for this group may come late, but there are effective tools to accelerate the savings process, and one is the focus of this article.

Most CPAs and their business owner clients are familiar with the popular company retirement plans available. These include Sec. 401(k) plans, simplified employee pension plans (SEPs), SIMPLE IRAs, and profit-sharing/money purchase plans. Yet, there are other less well-known, but much more generous, retirement plans designed specifically for late-blooming savers. One of these is related to a traditional pension plan (formally known as a defined benefit plan), which historically has had some drawbacks that have caused its slow demise. But a newer, modified hybrid version of this older plan contains improved features that can help clients ramp up retirement savings and substantially reduce taxes with fewer downsides than traditional pension plans.

This modified pension plan is a gift from the U.S. Department of Labor (DOL) and the IRS.

It can accelerate the buildup of client retirement assets far beyond other popular plans that are available — and can be used in combination with other plans. The government rules for this plan have been refined and clarified over the last decade, and we now know it formally as a cash balance pension plan, or simply cash balance plan (CBP).

THE BASICS OF CBPs

Retirement plans come in two general types: defined benefit and defined contribution. Often referred to as a hybrid, a CBP is a defined benefit plan that has some characteristics of a defined contribution plan, where each participant’s benefit is stated in terms of an account balance. Let’s say, for example, a participant has a cash balance in the plan of $200,000 upon retiring at age 67. The individual has a right to an annuity based on that amount. However, under most CBP plans, the individual could instead choose a lump-sum payment, which generally may be rolled over into an IRA or another employer’s retirement plan if that plan permits it.

Unlike a traditional pension plan in which an individual who retires is promised a monthly payment for life, a participant’s retirement benefit in a CBP is determined by the account balance — and these are often referred to as “hypothetical accounts” because they do not reflect actual contributions or gains/losses incurred. Participants are entitled to the amount accumulated in the hypothetical account when they retire regardless of how well the plan’s investments have performed. In other words, the plan’s gains or losses on its investments do not alter the participants’ promised benefit amounts. The employer alone directs the investments and bears the investment risk.

In terms of operation, the employer annually credits each participant’s account with a “pay credit” (e.g., 4% of annual compensation) and an “interest credit” (a fixed interest rate return or index-linked variable rate). The employer targets the plan’s investments to cover these financial obligations. Because the benefit is stated in terms of an account balance, CBPs eliminate much of the actuarial uncertainty that has affected traditional defined benefit plans.

CBPs have grown in popularity in recent years, with more than 10,000 plans in place covering over 10 million participants in 2019, according to a recent analysis. Many blue chip companies, medical firms, and law firms in the United States offer them to employees. The vast majority of CBPs cover 100 or fewer participants, so it is clear these plans are mainly used by small businesses. The number of these small-sized plans more than tripled over the past decade.

For successful small businesses and professional practices, CBPs can significantly reduce tax liabilities and accelerate owner retirement readiness. Some factors indicating that this type of pension plan may be right for a client can be found in the sidebar, “Which Clients Benefit Most From Cash Balance Plans?”

ADVANTAGES IN GENERAL

CBPs have many pluses for small businesses. One is that business owners potentially can contribute three or four times the dollar limits of other types of retirement plans such as 401(k)s. The contributions are deductible business expenses, potentially saving the owners tens of thousands of dollars in annual taxes. There is another benefit as well: These plans help to attract and retain talent.

A further advantage of CBPs is that they are easier for plan participants to understand than traditional pensions. As noted above, benefits are stated as an investment balance, unlike traditional pensions, where an actuarial retirement income is calculated many years out into the future. The stated-balance concept makes CBPs a hybrid plan with characteristics of both a 401(k) and a pension.

CBPs also provide significant flexibility. Partners/shareholders can receive different contribution amounts. Owners can set different “classes” and contribution levels for employee groups that provide for more flexibility in allocating retirement plan benefits.

Further, contributions on behalf of nonowner employees are limited and yet significant enough to meet Employee Retirement Income Security Act (ERISA) and DOL “gateway” requirements. Contributions can also be structured as a dividedup fixed-dollar amount or a percentage of pay. These provisions are established during plan design.

As with other types of retirement plans, the investments in a CBP grow tax-deferred, accelerating retirement wealth building. At retirement (or at plan termination), assets in both the CBP (and a 401(k) plan if paired with the CBP) can be rolled into IRAs and continue to grow tax-deferred until withdrawn. The rollover feature (often not available with traditional pension plans) is one of the things plan participants appreciate most about CBPs.

In terms of operating a CBP, the plan investments can be professionally managed as a single pooled (commingled) balance just like large pension plans. Additionally, the plan assets are shielded from creditors in the event of lawsuits or bankruptcy.

OTHER CONSIDERATIONS

Some potential drawbacks should be kept in mind, too. Because participants are guaranteed the amount in their hypothetical account upon retirement, the business bears the risk of poor investment performance. In addition, CBPs can be more costly for businesses to operate than some other types of plans, in part because of the need for the services of actuaries. Note, too, that the business must have a reliable cash flow to be able to commit to crediting each participant’s account annually.

CONTRIBUTION LIMITS

One of the main reasons businesses adopt CBPs, as previously noted, is that contribution limits are substantially higher than for other types of retirement plans.

CBPs are structured to target an allowable maximum income at retirement. This amount is indexed for inflation. Currently, owners and participants can build their personal pension to the actuarial equivalent of a lifetime income of $245,000 at age 62 (which is derived from the maximum allowable pension balance of $3.1 million for 2022).

The IRS also specifies the maximum salary income that can be used in the annual contribution calculation: $305,000 in 2022. Note that if a client reports artificially low salaries or earnings, this can limit annual contribution levels — contributions cannot exceed reported salary levels. Actuaries use income on Form W-2, Wage and Tax Statement; box 14 of partnership Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc.; and line 31 of Schedule C, Profit or Loss From Business, as primary sources for determining client salaries/earnings.

Cash balance contributions are set annually to ultimately target the finish line pension balance of $3.1 million, and the contribution amounts vary by year based largely on the age and income levels of participants, estimated years to retirement, and the pension’s long-term investment experience. Each year, the actuaries calculate the numbers for your clients and then provide a range of allowable contributions. Older individuals are allowed higher contributions because there is less time to compound and accumulate the maximum balance of $3.1 million prior to retirement. Some examples of allowable annual contribution amounts for 2022 appear in the table, “Sample Annual Contribution Limits by Age” (below).

TAX BENEFITS

A significant, if not the most important, element of CBPs is the tax deduction they provide. When federal income tax rates top out at 37% as they do now, cash balance contributions can reduce taxes substantially for key earners — very often tens of thousands of dollars in annual tax savings. In addition to federal tax savings, plan contributions can lower state and local taxes, which range from zero to as much as 13.3% in California.

In all the following ways, contributing to a CBP may reduce or eliminate taxes:

• Corporate taxes: Cash balance contributions are a deduction against business income.
• Personal federal taxes: If a shareholder or partner receives a Schedule K-1 as a result of corporation or partnership profits, the individual’s personal federal taxes can be reduced by a cash balance contribution.
• Top marginal income: The top marginal tax rate is 37% for individuals earning over $539,900 ($647,850 for married couples in 2022). A cash balance contribution that reduces income for a married couple below $647,851 will result in tax savings plus a reduction in the marginal income tax rate.
• Personal state taxes: As noted above, state tax rates can range widely from zero to 13.3%. Plan contributions can reduce the amount of tax owed.
• Personal investment tax: A CBP deduction may put a household under the net investment income tax threshold, eliminating the need to pay the 3.8% net investment income tax on unearned net income imposed on individual earnings over $200,000 ($250,000 for married couples). This surtax applies to investment income such as capital gains, dividends, and rental property income.
• Medicare tax: There is an additional 0.9% Medicare payroll tax on wages and self-employment income above $200,000 ($250,000 for married couples). Cash balance contributions can lower income to reduce this tax.
• Qualified business income (QBI) deduction: For some business owners and professionals, a CBP contribution could result in eligibility for the QBI deduction. This deduction is provided to companies that are structured as passthrough entities — sole proprietorships, partnerships, and S corporations. Taxpayers who qualify receive a 20% deduction of the income on their tax return. Many professional businesses (doctors, attorneys, consultants, actuaries, CPAs, etc.) do not qualify for the QBI deduction unless their income is below certain levels ($220,050 for a single return and $440,100 for a married couple filing a joint return for 2022).

LOGISTICS OF A CASH BALANCE PLAN

To make a CBP compliant and successful, a variety of players are needed. These include a custodian (who holds the plan’s assets); a record-keeper (who tracks each participant’s balance in the plan, including contributions and withdrawals and investment earnings); the third-party administrator (who ensures all the ERISA and DOL rules are followed, such as the preparation of an annual actuarial report, as well as that regulatory updates are provided to owners and participants and that the Form 5500, Annual Return/Report of Employee Benefit Plan, is filed); and, finally, the investment manager.

The plan’s annual costs are a function of hiring high-level professionals to manage this separate entity, the pension plan. For CBPs with only a handful of participants, startup fixed costs can run from $2,000 to $3,000, and ongoing annual costs can be about $3,000 (for four to five participants). Costs rise incrementally for larger plans. In addition, there may be Pension Benefit Guaranty Corporation premiums to pay, and the money manager (who targets investment returns to the trust document’s stated interest benchmark) will typically charge a fee equal to a percentage of assets.

The starting point for any pension plan is a company census that includes owner and employee demographic information — including age and salary level. This information is provided to the third-party administrator, who uses it to creatively structure the plan documents based on owner/ principal goals. A good third-party administrator will create a plan trust document that includes language to accommodate flexibility in needs or goals.

The trust document is then provided to a custodian firm — most often a brokerage custodian — that can set up the account and hold plan assets. It is important to note that most CBPs are paired with a 401(k) profit-sharing plan to maximize contributions and allow for plan funding flexibility.

After recent regulatory changes, contributions to the CBP can now be made up until the entity’s tax filing date including extensions.

A VALUABLE OPPORTUNITY FOR THE RIGHT BUSINESSES

By adopting CBPs, business owners can quickly build up their own retirement account, generate large tax savings for themselves, and encourage the dedication of valuable talent. These hybrid pension plans tap into business cash flow to help accelerate a business owner/professional’s retirement savings while generating significant tax benefits for them and other participants. Informed CPAs can connect clients to these plans to help them maximize the rewards of their successful businesses.

Which clients benefit most from cash balance plans?

A client may be a good candidate for a cash balance plan if the following conditions exist in whole or part:

• The client’s business is profitable with between two and 10 employees, and the client is a high-earning professional or a key owner of a partnership.
• The client is over age 35.
• The client (and business partners, if any) have several hundred thousand dollars of salary or flowthrough Federal Insurance Contributions Act income.
• The client is interested in making larger contributions than allowed in a SEP-IRA or 401(k), which are limited in 2022 to $61,000 for participants under age 50.
• The company’s cash flow is available to make large ($100,000 or more) retirement contributions for more than five years.
• The company is willing to make limited contributions for nonowner employees (usually 5% to 7% of pay). These contributions generally are coordinated with the company’s safe-harbor 401(k) or profit-sharing plan.

About the author

Grant S. Donaldson, CPA, MS, is an investment adviser who founded the financial advisory firm Tudor Financial, which now serves clients in over 30 states. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.

LEARNING RESOURCES

Governmental and Employer Retirement Plans Process

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AICPA RESOURCES

Articles

“5 Key Benefits of Cash Balance Plans,” The Tax Adviser, Sept. 2018

“Why Small Business Owners Should Have a Qualified Retirement Plan,”Tax Insider, July 19, 2018

“Cash Balance Plans for Professional Practices,” JofA, March 2015

Podcast episode

“Building Business Owner Wealth With Tax Advantaged Plans,” AICPA PFP Section, Sept. 9, 2022

Online resource

Cash Balance Plans Primer

For PFP Section members

Guide to Financial and Estate Planning, Vol. 2

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Membership in the Personal Financial Planning (PFP) Section provides access to specialized resources in the area of personal financial planning, including complimentary access to Broadridge Advisor. Visit the PFP Center. Members with a specialization in personal financial planning may be interested in applying for the Personal Financial Specialist (PFS) credential.