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Lane Keeter, CPA

Partner: Tax Consulting, Estate Planning, and Heber Springs Managing Partner

Cash Balance Pension Plans – Are They Right for Your Business?

In recent years, a hybrid form of pension plan called a Cash Balance Pension Plan (or CBP for short) has become increasingly popular among, in particular, successful small businesses with a limited number of owners. One reason for this is that the owners of the business can often contribute as much as three to four times more than the dollar limits that are placed by law on other types of retirement plans such as SEPS, SIMPLE IRA plans, 401(k) plans and the like. This makes them a very attractive tool for planning and funding retirement.

Retirement plans generally fall into one of two categories – defined benefit plans and defined contribution plans. A defined benefit plan is one where the benefit at retirement is generally a targeted, actuarially determined amount that the employee is assured of receiving. A defined contribution plan, on the other hand, is one in which an account is established for the employee into which contributions are made and invested, and the future benefit is determined based on the contributions made and the investment results of the account, thus the future amount is not guaranteed and could be lower or higher than expected. 

I use the term "hybrid" because, while a CBP is a type of defined benefit plan, it also has characteristics of a defined contribution plan. In other words, a CBP seeks to offer some of the best features of both. 

With a CBP, participants don't have an actual account for just themselves, but rather have a "hypothetical" account. This hypothetical account doesn't reflect actual contributions or investment results. Rather, it is credited with a pay credit (a percentage of pay) and an interest credit (either a fixed rate or one that is index-based). When the participant retires, they are entitled to the amount accumulated in the hypothetical account regardless of how well the plan's investments have done.

Like a defined benefit plan, the employer is required to make annual contributions, which are determined by an actuary. It is the employer that directs the investments, but also that bears the risk, not the employee. By contrast, with a defined contribution plan, for the most part the employer can determine year to year how much if any it will contribute to the plan, and the risk of loss is borne by the employee participants.

Retirement benefits are usually expressed in the form of a lifetime annuity, but lump sum options are allowed. Also, benefits are usually insured by the Pension Benefit Guaranty Corporation. 

The most significant advantage of a CBP over other plans, as stated earlier, is the ability for owners to contribute and take tax deductions in much larger amounts than other plans. Therefore, they tend to be right for companies with owners seeking to contribute more than the yearly maximum for SEPs or 401(k)s, which for 2023 is $66,000. CBPs can also be paired with a 401(k) plan for funding flexibility and higher contributions.

Another advantage is flexibility. CBPs can provide for differing contribution amounts for different owners and can set different contribution classes for employee groups. The employer will need to be prepared to offer some level of contributions for employees that are not owners, usually in the 5 to 7.5% of compensation range.

CPBs also tend to be easier for employees to understand than traditional pension plans. This is because participants have a benefit account balance that is known to them. 

And finally, a CBP can be an effective tool for owners who have used their past earnings to build up their business instead of funding retirement, to play catch up in establishing a solid, stable retirement financial situation.

For the right business, a CBP can help business owners save significant amounts of income tax, quickly build up their retirement savings and retain valuable employee talent. Such plans, however, are complex, so if you think one may be right for your business, care should be taken to consult someone experienced with CBP formation and ongoing qualifications. 

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