Cash Balance Plans for Business Owners: How They Work, Costs, and Who They Fit

Owners who already max out a 401(k) or SEP and still have taxable income they would like to shelter sometimes hear about cash balance plans. These plans can be powerful for the right business and a poor fit for the wrong one. The right way to think about them is as a commitment with a big payoff, not a trick.

What it is

A cash balance plan is a type of defined benefit pension plan. Unlike a traditional defined benefit plan that promises a monthly pension based on salary and years of service, a cash balance plan states each participant's benefit as a hypothetical account balance. The account grows through annual "pay credits" (a set dollar amount or percentage of pay) and "interest credits" (a stated rate or an index-based rate). At retirement or termination, the participant can generally take the balance as a lump sum, often rolled into an IRA, or as an annuity.

The plan is funded by the employer, and the employer bears investment risk: if the plan's investments do not earn the credited interest, the employer must make up the difference. Because it is a defined benefit plan, the maximum benefit is governed by defined benefit limits, and contributions are determined each year by an actuary.

Why owners use it

The maximum deductible contribution grows with age. An owner in their 50s or 60s with high stable income may be able to contribute multiples of what a 401(k) profit-sharing plan allows. The limit depends on the individual, their age, and plan design, and it is generally most valuable for owners age 45 and above with substantial income who want to save more in a compressed period.

Contributions are deductible to the business, and the plan's investments grow tax-deferred. Distributions are taxable when taken, unless rolled over.

Who tends to fit

Owners with high, consistent income who can commit to annual contributions.
Owners age 45 to 70, for whom the age-based limit is larger.
Small firms with few employees or a workforce that is either small or young, because the cost of covering employees is part of the design.
Professional practices and closely held businesses with stable cash flow.
Owners with retirement savings goals that exceed 401(k) limits.

Who tends not to fit

Volatile income businesses. The required contributions do not shrink because a year was bad.
Businesses that plan to reinvest heavily and need flexible cash.
Owners younger than early 40s, for whom the benefit is smaller.
Businesses with many employees where the cost of covering them offsets the benefit, though plan design can help.
Owners uncertain about staying in business for several years.

Employees and nondiscrimination

Cash balance plans must comply with coverage, nondiscrimination, and minimum participation rules. Employers generally must cover a broad group of employees, and the benefits for employees must fall within permitted ranges relative to the owner. Practically, many small employers pair the plan with a 401(k) with a profit-sharing formula that allows owners to receive higher employer contributions while giving employees a specified minimum. Design requires an actuary and a plan administrator.

Funding rules and commitments

Minimum required contributions: each year the actuary calculates a minimum and maximum contribution. The employer must contribute at least the minimum by the deadline. Failing to do so can lead to excise taxes.
Flexibility within a range: the employer has a band between the minimum and maximum to choose the deductible contribution.
Multi-year expectation: plans are intended to be permanent. Terminating a plan after a short period can raise concerns about whether it was a bona fide plan and can cause complications with benefit limits, though plans can be terminated for legitimate business reasons.
Interest credit risk: if investment returns lag the interest credit, the employer must fund the difference. Many plans use conservative investments to limit volatility.

Costs and administration

Expect:

Actuarial fees for valuations and certification each year.
Third-party administrator fees for plan documents, testing, and filings.
Annual Form 5500 filing with actuarial schedules, and possibly PBGC premiums for covered plans (professional service employers with 25 or fewer employees are often exempt from PBGC coverage under certain rules, but check).
Investment management costs.
Employee contribution costs if you have staff.

Fees can be significant relative to a simple 401(k) but small compared with the tax savings in successful cases.

Combining with other plans

Many small businesses adopt a cash balance plan alongside a 401(k) profit-sharing plan. The combined deduction limits apply, and the 401(k) employee deferral limit is separate from the cash balance contributions. The overall deduction limit for combined plans is generally the greater of a percentage of compensation or the amount required to fund the defined benefit plan minimum, subject to the rules. This is complex and requires professional design.

Tax planning uses

Reducing high taxable income in strong years.
Accelerating retirement savings late in a career.
Planning for the sale of a business where the owner wants to build assets outside the business.
Coordinating with the QBI deduction: contributions reduce taxable income and interact with qualified business income limits. See QBI deduction.

A plan for an S-corp owner is based on W-2 compensation, so the salary decision affects the benefit formula. See retirement plans for S-corp owners.

Risks and cautions

Cash flow burden in slower years.
Complexity and reliance on actuaries and advisers.
Promoter marketing. Beware of anyone who promises a specific tax savings or minimizes the funding obligations.
Plan termination issues. Consult professionals.
Investment risk on the employer.
Tax law changes can affect limits.
Interaction with other planning, such as sale of a business or owner departures.

Questions to ask a provider

What is the maximum annual contribution for me at my age, with my compensation?
What is the minimum required contribution, and what happens if profit falls?
How many employees will be covered and at what cost?
What is the projected all-in annual cost of administration and actuarial services?
How do you handle investments and interest credits?
How would we wind down the plan if we needed to?
Are you experienced with my type of business?

Alternatives

If a cash balance plan is too heavy, a solo 401(k) or SEP IRA can get much of the savings for owners without employees. See solo 401(k) vs SEP IRA.

If you are curious whether a cash balance plan could work for your business, AE Tax Advisors can help you evaluate the tax and cash-flow side, and a discovery call is a good first step. Plan design requires a qualified actuary and administrator.