Cash balance plans allow you to save a lot and get big tax deductions.
Benefits: Cash balance plan contribution limits increase with age. No matter how old you are, the limits for a cash balance plan are always higher than those for a 401k plan. Let’s look at a detailed comparison
(401K+Profit Sharing+Cash Balance*45% combined tax rate)
Companies make those contributions for their plan participants, so the amount is deductible to the company. For owners, those tax savings can flow through to their individual tax returns. Savings grow tax deferred, so participants have potentially saved a much bigger pool of assets when they retire. It is important to understand you can have a 401k plan, a profit-sharing plan with the 401k, and a cash balance plan, and are able to contribute the maximum to all. As an example, in the chart below, a person aged 60-65 can contribute up to $344,500 in a single year if they maxed out the 401k, profit sharing plan, and cash balance limits. One key point, the IRS limits the maximum saved in a cash balance plan to 2.9 million.
Potential Drawbacks- A cash balance plan is a large financial commitment. They are best used by businesses with predictable incomes which have been consistent for a long period of time. The IRS wants your plan to be in place for at least 5-7 years, and asks that contributions are similar during the entire time. It is possible to change the contributions, but there needs to be a documented business reason. You must cover 40% of your workforce, or up to 50 participants. You also will be giving those employees from 3%- 7.5% of their salary. Cash balance plans are a good fit for small businesses with an owner and a few employees, or law or medical enterprises which can cover both partners and administrative employees.
Plan participants earn a guaranteed benefit (rate of return).
Benefits: Savings in a plan participants cash balance plan won’t fluctuate based on investment performance. There is an interest crediting rate (usually 4-6%), and participants get the contribution each year plus what they earn from the interest crediting rate. Plan assets are pooled into one trust account and managed by professionals, and each employee receives a statement itemizing their own account balance.
Potential Drawbacks: Owners must fund the plan and its interest crediting rate. If the plan’s assets earn more than the crediting rate each year, the business owner gets to reduce the contribution the following year. In the event the plan’s assets don’t earn the crediting rate, sponsors must make up the difference with more cash the following year. It is for this reason advisors and sponsors work with actuaries to design plans which fit and follow the interest credit rate amounts.
Cash balance plans are portable.
Benefits: Plan participants can move jobs and rollover the cash balance amount into a rollover IRA, like a 401k plan.
Potential Drawbacks: Cash balance plans are pooled accounts, and everyone has the same interest credit rate. The investment account has the same investments for everyone. There is no variation between participants on what investments each has. Keep in mind the cash balance plan is typically used in combination with 401k plans and profit-sharing plans, which is where individual differences in investment approaches can be implemented.
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