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Winter 2009

Cash Balance Plans

Jill Thompson
Vice President for Financial/Consulting Services, Anesthesia Business Consultants, LLC (ABC)

An increasing number of highly compensated individuals are finding that contributions made to their 401(k) and profit sharing accounts have reached the maximum allowable amounts. Now those same individuals can increase their contributions through the increasingly popular Cash Balance Plan.

As the fastest-growing retirement plan in the United States, 401(k) plans allow participants to contribute up to $22,000 for 2009, depending on the participant’s age. A profit-sharing plan allows employers to contribute another $32,500 on behalf of the participant. However, once the annual maximum contribution has been reached ($54,500 for those 50 years of age and over or $49,000 for those under 50 years of age), then no further contributions can be made for that participant on a pre-tax basis.

On the other hand, a Cash Balance Plan contribution can be as much as $200,000, which varies by age, per year. For individuals making in excess of $245,000 per year, and who have a need for additional tax deductions, a Cash Balance Plan provides a welcome respite from the low retirement plan contribution levels available through a 401(k)/profit sharing plan.

Since 1985, when Bank of America implemented the first Cash Balance Plan, thousands of companies have followed suit. Citing predictability and ease of administration, firms often opt for Cash Balance Plans because of portability, which helps attract employees, especially the young, mobile workforce in high-turnover industries. Initially, corporations with more than 10,000 employees, such as AT&T, Bell Atlantic and IBM, adopted Cash Balance Plans. However, a change in the tax law in 2001 allowed contributions to increase by as much as 60%, making Cash Balance Plans much more attractive to successful businesses and professional service firms. The Pension Protection Act of 2006 further cemented the future of Cash Balance Plans by allowing for substantial increases in contributions and tax savings.

A Cash Balance Plan is a defined benefit plan that specifies the amount of contribution to be credited to each participant. The contribution can be either a flat dollar amount or a percentage of pay. The plan credits interest on those contributions at a guaranteed rate. Each participant has an individual account which resembles the accounts in a 401(k)/profit sharing plan. All participant accounts are maintained by the plan actuary who generates annual participant statements.

The guaranteed rate of return is spelled out in the plan document and is not dependent on the plan’s investment performance. The rate of return changes each year and for many plans is equal to the yield on the 30-year Treasury bond, which in recent years has been around 5%. Once participants terminate employment, they are eligible to receive the vested portion of their account balance determined by the plan’s vesting schedule.

Companies that are good candidates for Cash Balance Plans have one or more of the following characteristics:

  1. Owners who desire to contribute more than $49,000/$54,500 per year – a Cash Balance Plan allows for both an acceleration of retirement savings and a large tax deduction.
  2. Owners over 40 years of age who desire increased tax deductions or wish to catch up on their pension savings – the maximum contributions allowed in Cash Balance Plans are age dependent. Therefore, the older the participants, the faster they can accelerate their savings.
  3. Companies that have demonstrated consistent profit patterns – because a Cash Balance Plan is a defined benefit pension plan with required contributions, a consistent cash flow is important.
  4. Companies that are already contributing 3% or more to employees’ accounts or are at least willing to do so – while Cash Balance Plans are often established for the benefit of owners and other highly compensated individuals, other employees also benefit. The plan normally provides a minimum contribution of 5% to 7% of pay for the company’s other employees.

The types of businesses that are candidates for Cash Balance Plans include professional service businesses such as CPA and law firms, medical groups and family or closely-held businesses where there are a number of owners who are at their 401(k) and profit sharing contribution limit. Cash Balance Plans may not be right for everyone. Because they are a type of defined benefit plan, Cash Balance Plans require a commitment to specific contribution level for two to three years. It is important that a company display consistent profit patterns in order to consider a plan. One should also consider company demographics and company culture. Cash Balance Plans can allow for large contributions for select employees such as the owners; however, some company cultures dictate all employees are treated equally with regards to retirement plan contributions.

Cash Balance Plans have to be amended in order to change contribution levels because they are not profit sharing plans under which contributions can vary year to year, depending upon profitability. Employers can designate different contribution amounts for various participants. However, the frequency of amendments to change benefits may be restricted in the absence of a valid business reason. For example, if a company’s profit is not expected to support the Cash Balance Plan contribution, the plan can be amended. The plan can also be frozen or terminated.

If you are looking for additional tax deductions and need to catch up on retirement contributions, you may want to evaluate the merits of a Cash Balance Plan, which provides a significant opportunity to increase contributions into a qualified retirement plan, as well as defer taxable income.