Cash balance pensions: the pros and cons of small businesses

If you are a small business owner and your retirement is imminent in the near future, you might consider a cash balance pension plan. It can meet your retirement savings goals as well as the needs of your employees.

This type of employee retirement plan requires you to contribute a certain percentage of each employee’s annual salary (usually 5% plus interest credits) for retirement investment. Employees can also donate on their own behalf.

Key points

  • Cash balance pensions are the most attractive for owners of small businesses, mainly high-income earners, such as doctors’ offices and law firms.
  • It is worth noting that there are high restrictions on donations and preferential tax treatment.
  • It has some of the attributes of a 401(k), but the payment owed upon retirement is not affected by market fluctuations.

How the cash balance pension works

At retirement, the cash balance pension plan provides an option for employees (and their employers). They can take away the money reserved for them at once, or they can choose to pay monthly based on their balance. The monthly payment is based on the length of service and the highest salary for three consecutive years, as well as the individual’s life expectancy.

The good part, especially for older workers, the allowable amount of money that can be deposited is basically unlimited. The limit is set on the maximum allowable expenditure. In 2021, the pension payment limit is USD 230,000 per year. By 2022, the limit will increase to $245,000 per year. Returning to work from there, an older professional can invest approximately US$300,000 per year.

Similarities with 401(k)

The cash balance pension plan is a fixed benefit pension plan with a 401(k) distortion. The employer deposits a fixed percentage of each participant’s annual salary plus a fixed interest rate into each participant’s account.

A 65-year-old professional can pay up to $305,000 in 2022 and still be able to fund a 401(k) or IRA account.

However, as with any defined benefit pension plan, all investment risks are borne by the employer. Participants will not be adversely affected by fluctuations in the stock market.

High contribution limit

One aspect of the cash balance plan that is attractive to small business owners (especially those approaching retirement age) is that the level of contributions will increase as they age.

For example, for a 65-year-old, the maximum contribution by 2022 may be as high as $305,000. In addition, they can still contribute up to $27,000 to a 401(k) plan, which includes a catch-up plan. In other words, for the 2022 tax year, the annual contribution limit of the US Internal Revenue Service is US$20,500, but people aged 50 or above are allowed to contribute US$6,500 as a supplementary payment requirement.

For business owners who are unable to save for retirement, want the greatest tax relief and have available cash flow, a cash balance plan may be a good solution.

getting more popular

According to data from pension consultant Kravitz Inc., cash balance plans now account for approximately 25% of all defined benefit plans.

In recent years, they have become more and more popular. This growth is largely driven by individual business owners and high-income professionals (such as doctor groups, law firms, and other professionals). For high-income baby boomers, the cash balance plan may be the best in the world.

However, cash balance plans are not cheap for companies with employees. Employer contributions in a typical 401(k) plan may be about 3% to 6% of salary. The overall cost may be in the range of 5% to 8%. Participants’ accounts will receive an annual interest credit, which may be a fixed interest rate of 5% or a variable such as the interest rate on a 30-year Treasury bill.

The initial setup cost is usually between USD 2,000 and USD 5,000. Every year, the actuary must prove that the plan is adequately funded. This may result in annual management costs between US$2,000 and US$10,000.

Participant account

Each participant has a personal account, just like in a 401(k) plan. At retirement, participants can use their payments as an annuity, but in some plans, they can choose a one-time distribution, which can be rolled over to the IRA.

These plans increase retirement savings while providing higher tax relief than most alternatives. For older professionals who may not have enough savings, the benefits are huge.

Professional practices must have cash flow to fund these programs on a consistent basis, and must be willing to contribute to their other employees. The cash balance plan provides a certain degree of portability for employees who leave the company, as long as they enjoy benefits.

As with any pension plan, if the employer defaults on payments, the Pension Benefit Guaranty Corp (PBGC) shall provide benefits to the participants.

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