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Cash Balance Plan is perfect for businesses with partners and highly compensated employees, so that the contribution amounts can be decided up to certain IRS limits.
As an example, for a 50-year-old individual who is self-employed, the cash balance contribution can be $150,000 as compared to $57,000 to a SEP-IRA or $26,000 to a 401(k) plan.
Employment status: Self-employed
Three-year average income: 100,000 as W-2 compensation/Schedule C income/K-1 Income
Participant’s age: 50
This article covers the following concepts:
There are two types of pension plans in the market, defined benefit plan and a defined contribution plan. In a defined benefit plan, the benefit is communicated as a monthly annuity at a future retirement age. In the defined contribution plan, the benefit is communicated as an account balance in today’s dollars. The cash balance pension plan is a hybrid plan where the benefit is communicated as a dollar amount in today’s dollars and the annuity calculations are done at the back end.
This makes it very easy to communicate benefits to the owner or participants.
Any small or large business can set up a cash balance pension plan. Even a self-employed individual can set it up as long as there is significant money to contribute to the plan. Typical examples of businesses that set up a cash balance pension plan are:
A Cash balance pension plan is an employer-sponsored pension plan, so this is typically set up by a business. All types of businesses can set it up, however, a prudent decision needs to be made based on the goals and the profitability of the business. Even self-employed individuals and sole-proprietors can start a cash balance pension plan as long as the cost justifies the benefits earned.
The cash balance calculator is a must if you:
If you answered yes to the questions above, then it might be worth a lot of money to use our cash balance calculator and find out how much you can contribute to the cash balance plan. Our actuaries can design and administer a cash balance plan at a minimal cost whenever you are ready to get started. Our cash balance calculator is the only one available on the internet that can crunch complex actuarial numbers in a split second and generate a contribution report.
The answer is simple, to easily fix and communicate the benefits to the participants.
Most companies will have more than one participant in the pension plan. Each participant will also be of different age and derive a different compensation. Hence, each participant will accrue benefits at a different rate and such situations typically lead to a conflict if it is a small business.
Assume a situation where a company has three partners who are 40, 50, and 60 years old with different compensation amounts. It will be almost impossible to generate the same allocation for each of them year after year. Such situations are easily resolved by utilizing the cash balance pension plan design.
The partners in the above situation can agree to make a contribution of 80,000 for each so that the amount is the same for each irrespective of their age.
The other possible scenario is that the partners can agree to allocate $80,000 to the youngest partner, and $150,000 and $200,000 to the other two partners based on their proximity to retirement age.
All cash balance pension plans will have the following components:
Allocation Rate: The allocation rate is the amount that has to be contributed for each participant each year. This could be stated as a fixed dollar amount, or as a percentage of salary. The $80,000, $150,000 and $200,000 stated in the above example were allocation rates.
Crediting Rate: The cash balance pension plan will credit fixed interest based on the hypothetical account balance each year. For example, the crediting rate could be 4%, so the participant’s account balance will grow at the rate of 4% each year in addition to the allocations that are made.
For example, the cash balance pension plan document can state that the owner of the business receives an allocation of $125,000 each year. This amount is typically referred to as the ‘hypothetical account balance’
In the first year, the company will deposit the $125,000 to the owner of the cash balance pension plan account and an account balance certificate will be provided that states the allocation amount.
If the same individual were to have a defined benefit plan, the benefit would be stated as a monthly annuity of x dollars, starting at an assumed retirement age of 62/65, with interest rates assumed as a% for the first five years, b% for the next 15 years, and c% thereafter.
For a company with only one participant, the cash balance or defined benefit plan will generate the same retirement benefits. This is an important point to note!
Please discuss with your actuary the appropriate plan design for you. If you do not have an actuary, we can provide some insights into the appropriate plan design for you. Feel free to email us at info@pensiondeductions.com and we shall be happy to assist you.
To get an approximate estimate of how much you can contribute to a cash balance pension plan, please use our calculator on the right!
As it would be clear by now, a cash balance plan is based on the individual participant’s age and compensation. But what is compensation? Typically, earned income (income subject to self-employment taxes) has to be used as compensation. The IRS has very specific definitions of what income can be considered as compensation for a cash balance plan.
If your business is taxed as sole-proprietorship, you would file a Schedule C for the business. Your Net Schedule C is used for calculating the compensation for the purpose of the defined benefit plan contribution. This is typically done as follows:
Net Schedule C after all deductions – ½ FICA – Defined benefit plan Contribution
This is only a basic formula and there are ways in which the correct calculation has to be done. Please feel free to email us if you are a sole-proprietor and want to set up a defined benefit plan: info@pensiondeductions.com
If your business is a partnership, and taxed as a partnership, you can consider your K-1 income for calculating compensation for the purpose of a defined benefit plan. The calculation would broadly be along the following lines:
Net K-1 income after all deductions – ½ FICA – Defined benefit plan contributions
If your business is a Corporation and taxed as a Corporation, only your W-2 compensation can be used for the purpose of the defined benefit plan. S-Corp owners would also receive a K-1 from the business, but since the K-1 from a Corporation is not subject to self-employment taxes, it cannot be used as compensation for a defined benefit plan.
If your business is a partnership taxed as a corporation, only your W-2 can be used for the purpose of a defined benefit plan.
Compensation for a business that you do not own cannot be used for the purpose of the defined benefit plan. In this case, if you have a full-time job and a business on the side, you can set up a defined benefit plan for the business, but you cannot use compensation from your full-time job for the purpose of the defined benefit plan.
“I have a full-time job and a side business. Can I set up a defined benefit plan as I don’t really need the income from my side business?”
This is a common question that we come across. Many doctors are in this situation where they have a small practice on the side and a full-time job with a hospital. The income from the side business can be used to set up a defined benefit plan and the contributions can be maximized after compensation history has been built in three years. The same rules apply regarding compensation as we have elaborated in the types of compensation above. If the compensation is high enough for the first three years, almost 90% of the income in the business can be contributed to the plan after the three years.
Some retirement plans cannot be set up after a certain age, however, cash balance plans do not fall into this category. So if you have a significant amount of income after age 70, you can still set up a cash balance plan and contribute a large amount of money.
The IRS typically requires participants to take a taxable distribution from the plan after age 72 (was age 70.5 prior to the Secure Act passed in Dec-2019). However, the cash balance plan can utilize unique vesting schedule options to suspend the distributions for a few years. This will give you the option to defer taxes in high-income years and roll over the remaining balance to an IRA.
Setting up a cash balance plan requires a certain amount of groundwork that needs to be put in before you can start contributing to the plan.
At first, a calculation needs to be performed about how much you can contribute to a cash balance plan. Unlike 401(k) and profit-sharing plans, contributions to a cash balance plan vary from person to person. They are typically based on the age of the individual and the compensation history. You can calculate an estimate using our online cash balance calculator on this page. A final calculation needs to be performed by an actuary though.
Once you have a final estimate from the contributions, you will need to collaborate with your CPA to ensure that you have sufficient cash flow to contribute to the cash balance plan. Once the amount has been decided between you and your CPA, the actuary will need to draft the plan document for you.
For example, your actuary may calculate that you can contribute $200,000 to the cash balance plan in the first year. However, you might want a lower contribution amount and your actuary needs to be informed of that. Once you, the actuary, and your CPA agree on a contribution amount, you are all set to go ahead with the next steps.
Every cash balance plan requires a plan document which will list all assumptions of the pension plan and ensure compliance with all IRS rules and regulations. This document has to be drafted by an actuary before you can set up the investment accounts for the plan. A new TIN also needs to be registered for the pension plan as it is a distinct legal entity. The actuary will customize a plan document based on the contributions you need. Make sure your actuary provides you with a plan document that is pre-approved by the IRS so you don’t need to go through the hassle yourself. You can read more about a pension plan document here.
After the plan document has been drafted, you are all set to open the investment account for the plan. You should reach out to your financial advisor or a broker to set up the accounts. Make sure you tell them to open a ‘qualified account’ so that the investment gains are not taxed at the source.
You can start making contributions to the plan as and when free cash flow is available once the investment accounts are open. For the first year, the contribution will be what was decided between you and the actuary. The actuary will calculate a range for each subsequent year, along with a recommended contribution amount. You are required to contribute within the range to avoid overfunding or underfunding the plan. The deposits can be made until you file the tax returns for your business.
All qualified plans are required to file annual returns with the IRS. Note that these returns are different from the company tax returns and your personal tax returns. Also, note that the CPA or financial advisor cannot file these returns since these are required to be certified by an actuary.
The actuary will prepare a form called the Form 5500SF and certify another form called the Schedule SB. You will need to sign the form as the plan sponsor and the actuary will file it electronically. The penalties for not filing these forms run into hundreds of dollars and the pension plan could end up getting disqualified.
If you are a self-employed individual and interested in exploring the idea of a cash balance plan for yourself please email us at info@pensiondeductions.com. We specialize in this area and can provide you with valuable advice and services that could end up saving thousands of dollars and giving a boost to your retirement planning.
If you do not have an actuary, please reach out to us at info@pensiondeductions.com and we can design the proposal.
If you are a small business owner with employees you will need to set up a cash balance pension plan and a profit-sharing plan together.
As explained earlier, contributions to the cash balance pension plan can be higher, and you may not want to contribute so much to your employees. Including your employees in the DB plan also brings up the question of minimum contributions each year and the need to fund the plan aggressively if the investments don’t perform or produce a negative return. Therefore, we recommend that you set up both plans together and this will allow you to optimize the contribution amounts for yourself.
As pension administrators and consultants, we can design and administer these plans. Please reach out to us at info@pensiondeductions.com and we will customize the plan design for you. You should send us an excel sheet with the date of hire, date of birth, compensation, and the number of hours worked for each of your employees. We can then design the plan based on your specific circumstance and tell you exactly how much the business owner can contribute for themselves and what needs to be contributed for the employees.
In most situations, we can channelize more than 80-90% of the total contributions to the business owners and the rest will be an allocation to the employees.
Draft the Plan Document for the Cash Balance Pension Plan
Set up the Cash Balance Pension Plan investment accounts
File with the IRS
Contact an Actuary or a Pension Consulting Firm (Like us!)
Talk to your CPA
This is a common question that we come across. Many doctors are in this situation where they have a small practice on the side and a full-time job with a hospital. The income from the side business can be used to set up a cash balance pension plan and the contributions can be maximized after compensation history has been built in three years. Same rules apply regarding compensation as we have elaborated in the types of compensation above. If the compensation is high enough for the first three years, almost 90% of the income in the business can be contributed to the plan after the three years.