- Increase Retirement Savings - Meet The Cash Balance Plan
- June 5, 2003
- Law Firm: Sirote & Permutt, P.C. - Birmingham Office
The traditional defined contribution plan (i.e., a profit sharing plan) is subject to an annual cap on participant contributions. For 2002, the cap is $40,000. Although the cap has experienced some increases over recent years, qualified plan participants have been restricted in saving toward their retirement. Recently, retirement plan advisors have begun using another type of qualified retirement plan to supplement the traditional defined contribution plan. The second plan allows employees to accumulate more on an annual basis than $40,000. This plan is called a Cash Balance Plan.
A Cash Balance Plan is a qualified retirement plan that promises the employee an employer contribution equal to a percentage of the employee's annual pay. In addition to the employer contribution, a Cash Balance Plan also guarantees the employee a fixed rate of return on the employer contributions (the rate of return can be a fixed percentage, but it is usually tied to a variable index, such as the annual yield on a 1 year T-bill). The result is a plan that allows the building of value at a gradual and steady rate for plan participants, and while the Cash Balance Plan has the appearance of individual accounts, the fact is, the account is merely a record-keeping feature that defines an employee's accrued benefit at any point in time.
Example: Mr. Saver is the sole owner of his business that employs 5 persons, including himself. Mr. Saver's annual compensation is $200,000 and the other four employees have a combined annual compensation equal to $120,000. The business establishes, in addition to its profit sharing 401(k) plan, a Cash Balance Plan under which the business will contribute 10% of each employee's annual compensation. Thus, the business will contribute $32,000 ($320,000 x 10%) to the Cash Balance Plan. Mr. Saver's contribution will equal $20,000 and the contribution for the other four employees will equal $12,000. The total contributions for Mr. Saver each year will be $60,000 ($40,000 to the profit sharing 401(k) plan and $20,000 to the Cash Balance Plan).
Employees whose employers sponsor a Cash Balance Plan in addition to a profit sharing 401(k) plan would participate in both plans subject to the IRS' non-discrimination rules. An employee who is a participant in both plans could be able to receive the maximum contribution to the defined contribution plan ($40,000) plus whatever contribution the employee would be entitled to under the Cash Balance Plan. Thus, Mr. Saver in the above example would, with the addition of a Cash Balance Plan, receive an additional $20,000 in retirement savings for the year in question for a total of $60,000.
It should be noted that a Cash Balance Plan used in conjunction with a traditional defined contribution plan is not without limits. The Internal Revenue Code places a limitation on the amount an employer may contribute to a retirement plan and still receive a deduction for the contribution. Currently, the limit imposed by the IRS is equal to 25% of an employer's payroll plus employee salary reduction contributions. This limit applies irrespective of the number of plans maintained by an employer. In other words, if an employee sponsors two retirement plans, the deduction limit will apply to both plans in the aggregate.
Thus, using our example, Mr. Saver's business could contribute up to $80,000 ($320,000 x 25%) to the Cash Balance Plan and profit sharing 401(k) plan. Assuming the contribution to the Cash Balance Plan is 10% of an employee's annual compensation, the contribution to the Cash Balance Plan would equal $32,000 ($320,000 x 10%) leaving $48,000 for the defined contribution plan. Assuming Mr. Saver's contribution to the defined contribution plan is $40,000, the other four employee's would share the remaining $8,000. Of the $80,000 contributed to both plans, Mr. Saver received $60,000 or 75%.
For many years, the IRS has approved the use of Cash Balance Plans and while employers are only now starting to use Cash Balance Plans in conjunction with their existing defined contribution plan, the concept is not a new one. If an employer is interested in adding a Cash Balance Plan to its existing defined contribution plan, a feasibility study can be conducted at a relatively small cost. The feasibility study will illustrate the extra benefits provided to the management/executive employees so that the employer can make an enlightened decision.