Is a cash balance plan your retirement solution?


One of the fastest-growing retirement savings options for small firms is a little-known hybrid called a cash balance plan.

Plan designers say it is ideal for an owner earning more than $250,000 a year who wants to maximize pretax retirement savings over and above what is contributed to a 401(k) or pension plan.

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During the past two years, cash balance plans have particularly caught on with owners and principals of professional services firms, like medical practices, because these plans afford high wealth individuals the ability to sock away savings and take the bite out of taxes. Medical and dental groups account for 37 percent of all cash balance plans nationally, according to the 2012 National Cash Balance Research Report issued by Kravitz, Inc., a designer and administrator of employer-based retirement plans.

“We expect to see continued growth in the healthcare sector as the economy adjusts to the requirements of the Patient Protection and Affordable Care Act,” the report said.

Cash balance plans defined

Cash balance plans combine the high contribution limits of traditional defined benefit plans with the flexibility and portability of 401(k)s. The plan specifies both the annual contribution to be credited to each participant and the interest to be credited at a guaranteed rate based on those contributions.

Benefits accrue quickly. Plan participants are fully vested in the accrued benefit after just three years of service.

Because a cash balance plan is a qualified retirement plan, the investment and interest earned grow tax-free until a distribution is made. Additionally, assets are protected from creditors in the event of bankruptcy. Plans are usually insured by the Pension Benefit Guaranty Corporation.

How it works

Each employee is given an account. Unlike a 401(k), in which the employee contributes to the account and elects how it is invested, the cash balance plan is funded solely by the employer either quarterly or annually.

Plan investments are held in a single trust fund by an actuary. Fund assets are managed as a pool and invested conservatively by the firm’s chosen registered investment manager.

Annually, participant accounts are credited with the pre-set contribution based on the plan document. The contribution amount takes into account age, compensation, length of employment and class of employee (i.e., owner, key employee, or rank and file).

The contribution can be a percentage of pay or a flat dollar amount. The older an employee, the larger the allowable contribution, which gives those nearer retirement the ability to play catch-up if they haven’t saved enough for their retirement.

The owners and key employees receive a much larger contribution than other employees, and the plan can restrict which category of employee is eligible to participate. However, the IRS requires nondiscrimination testing by an actuary annually to ensure that contributions made for highly compensated individuals reasonably relate to the amounts contributed on behalf of lower-paid employees.

The maximum contribution for 2013 is $205,000, but the amount can be much less, based on actuarial restrictions, if a practice is “top heavy.”

Tax deductions for contributions are similar to other tax-qualified retirement plans. In a partnership, contributions to a cash balance plan are allocated like other firm expenses.

The interest rate to be credited is determined when the plan is established and is usually tied to a bond index. However, the plan’s actual investment performance may be higher or lower.

Although the employer bears the investment risk, account balances are paid out only upon termination of employment. They are subject to a vesting schedule so that a fund has some time to recover from market losses.

A plan can be amended if a practice does not earn sufficient profits to support its annual contribution. But amendments must be made before an employee works 1,000 hours in a plan year.

The law caps the amount you can accumulate in an account at $2.5 million. Upon terminating their employment, participants can take the vested portion of their account balance as an annuity or in a lump sum, which can be rolled over to an IRA or other retirement plan.

Money in a cash balance retirement plan cannot be withdrawn until age 59 1/2. Early withdrawals incur a 10 percent penalty in addition to the taxes due on the amount withdrawn.

Pending IRS proposals

In October 2010, the Internal Revenue Service clarified what it defines as a market rate that cash balance plans could use as the plan’s interest credit. The rate of any interest credit for any plan year cannot exceed a market rate of return.

At the same time, the IRS proposed a 5 percent interest cap for employers that use a fixed percentage and a 4 percent fixed-rate cap for plans that credit the greater of a fixed rate or the rate on certain bond-based indices. Plans using an actual rate of return on plan assets must be diversified to minimize the volatility of returns.

No final rule has been announced on this proposal, but the IRS has said the earliest effective date would be Jan. 1, 2014.

Cash balance plans aren’t for everyone, especially since upfront costs are higher than establishing a 401(k). Consult your financial adviser to determine whether your practice is a good candidate for this type of plan.