Planning for retirement is one of the most important financial goals that exist.
And not only does it involve the ability to defer gratification, opting to save and invest today to reap the benefits down the road, but it also involves complexity. When it comes to your business, there’s no one-size-fits-all approach to retirement planning. A standard 401(k) with safe harbor provisions is perfect for some. But for others, it needs a profit-sharing component, and for others, a defined benefit plan like a cash balance retirement plan could be best.
Navigating these options can challenge many small business owners, physician groups, and self-employed individuals.
If you’re interested in understanding the ins and outs of a cash balance plan, including whether it could be a good fit for your business, read on to learn more.
What Is a Cash Balance Plan?
A cash balance plan is a type of retirement plan known as a defined benefit pension plan.
It differs from defined contribution plans like 401(k)s because instead of your retirement payout depending solely on your contributions and investment growth, your cash balance payout depends on the stated benefit your employer is promising, based on your account value. But, a cash balance plan can be unique, as it combines some aspects of defined contribution plans with elements of defined benefit plans.
How Does a Cash Balance Plan Work?
Typically in a cash balance plan, the employee or “participant’s” retirement account is credited each year with a “pay credit” and an “interest credit.”
Interestingly, the fluctuations in the account value do not affect the amount an employee receives in retirement. This means that the investment risk is borne solely by the employer, not the employee, a key difference from 401(k)s or other defined contribution plans.
Let’s look at an example.
A typical “pay credit” could be around 5% of an employee’s yearly compensation. So, for an employee making $150,000 per year, the employer sets aside $7,500 per year. In addition, the employer calculates an interest credit that matches the 30-year treasury rate, averaging 3 to 4% per year.
After 40 years, the hypothetical account value is roughly $634k, assuming 3.5% interest per year and $7,500 contributions yearly.
Then, the retiring employee can either take the amount as a lump sum or receive a lifetime income stream based on the $634k account value.
This differs from a traditional 401(k) retirement plan because the employee knows exactly how much to expect in retirement income each year with a cash balance plan. Alternatively, a retiree’s 401(k) value will depend on how much they contributed and the investment performance over the years.
What Are the Benefits of a Cash Balance Plan?
There are many benefits to consider:
FOR EMPLOYEES
- Employers are responsible for contributions.
- You bear no investment risk.
- Participants receive a guaranteed benefit.
- Amounts can be rolled over.
- Limits are much higher than 401(k)s.
FOR EMPLOYERS
- With high contribution limits, owners can get big tax deductions and rapid retirement savings.
- Plans can be customized to fit the needs of your business.
- It can be a standalone plan or in addition to a 401(k) or other retirement plans.
- Owners can exclude employees in certain situations.
- It can help attract and retain top talent.
What Are the Drawbacks?
But, cash balance plans also have their drawbacks:
FOR EMPLOYEES
- Employees cannot contribute.
- Young workers with low salaries receive less in contributions due to low salary amounts.
- No control over investments or performance.
FOR EMPLOYERS
- Because they are customizable, they can be complex.
- They’re a big commitment since employers are responsible for contributions.
- Employers bear the burden of investment performance.
- Higher costs than 401(k)s.
Is a Cash Balance Plan Right for Your Business?
Determining whether a cash balance plan is right for your business comes down to understanding your goals, your business, and your needs.
At a high level, cash balance plans can be great for more established, higher-income businesses. That’s because the costs and commitment are generally higher than a traditional 401(k) plan. In addition, they’re a great fit for high-income owners, physician groups, or law-firm partners looking to supercharge their retirement savings while creating significant tax savings today.
TrueNorth Retirement Services Is Here to Help
If you’re interested in working with TrueNorth’s Retirement Team to help understand the benefits of establishing a cash balance plan for your small business, then we’re here to help.
TrueNorth Retirement Services is among the top retirement planning firms in Utah and Idaho, with offices in Salt Lake City, Logan, St. George, and Boise. Learn more by scheduling a no-cost consultation.
