What is a Cash Balance Plan? How It Works, Features and Eligibility

If you make mid to high six-figures per year, the contribution limits of a 401k or solo 401k might not be enough of a tax deduction. That’s where a cash balance plan can help. While they can be more complex to set up and maintain, the size of benefits are unmatched by defined contribution plans like the 401k.

Unlike a 401k where the contribution limits are defined each year, a cash balance plan is a defined benefit plan. Instead of limiting annual contributions, the amount of money the account can hold at retirement is capped at $3.4 million for 2023. The older you are, the more money you can put in each year to hit the $3.4 million number. Typical contributions made to a cash balance plan are between $100,000 to $300,000.

Overview

A cash balance plan is not as well known as something like a 401k. And because of its hybrid nature between a defined benefit plan and defined contribution plan, it can seem a little more complex to understand. Let’s go through a few of the main characteristics, features, and rules of a cash balance plan before we dive into the finer details

Major characteristics of a cash balance plan.

Major features of a cash balance plan.

Investing in a cash balance plan

Suitable candidates for a cash balance plan

What is a cash balance plan?

Most business owners are probably already familiar with the 401k. Retirement plans like the 401k, IRA, or even a solo 401k are considered defined contribution plans. As the name suggests, they define the contribution limit you can put in each year and the account balance does not affect your contribution limits. Once you hit those limits, there’s nothing more you can contribute pre-tax.

A cash balance plan is technically a defined benefit plan, similar to a pension plan. Instead of defining the amount you can put into the plan, a defined benefit plan defines the amount of money that you’re entitled to receive at some point in retirement (usually between age 62 to 65). The contributions today are the contributions needed to meet that future benefit, and your age and compensation determine how much you’ll be allowed to contribute annually in order to hit that defined amount.

Cash balance plan vs pension plan

While cash balance plans are technically “pension plans” the major difference is that pension plans pay out a fixed amount per month for the rest of your life. While this still an option with cash balance plans, normally people choose to receive a lump sum payment, which can then be rolled over into another pre-tax retirement plan like an IRA.

Cash balance plan vs 401k plan

One of the biggest differences between a cash balance plan and 401k is that the employer bears all the investment risk, and the employee is promised a fixed or variable rate regardless of investment performance. This means that the contribution amounts for a cash balance plan are partly determined by the performance of the plan’s investments.

With a cash balance plan, employees also have the option to receive their payments as monthly annuity payments rather than taking the lump sum payment.

Best candidates for a cash balance plan

The best businesses that should consider adopting a cash balance plan are ones with:

What business structures can set up a cash balance plan?

Any business structure can open a cash balance plan. Sole proprietorships, LLCs, partnerships, C corporations, and S corporations are all common structures that adopt cash balance plans.

Reasons to set up a cash balance plan

The biggest benefit of a cash balance plan is the ability to contribute larger amounts of pre-tax income than to a defined contribution plan like a 401k. Business owners who adopt a cash balance plan can benefit from significant tax savings immediately by being able to contribute $100,000 to $300,000. Assuming a 37% tax bracket, that’s $37,000 to $110,000 in federal taxes saved in one year, which can then be invested on a tax-deferred basis until retirement.

Here are some of the major pros and cons of adopting a cash balance plan.

Pros

Cons

Tax benefits

If you’re in the highest tax bracket of 37%, cash balance contributions can reduce your federal taxes by tens of thousands of dollars. It can also lower your state and local taxes, which can range from zero to 12.3% depending on where you live.

Contribution limits & deadlines

Contribution limits

Unlike a defined contribution plan like a 401k, your annual contribution limit is not fixed because you’re trying to reach a specific defined amount by retirement. It’s different for every individual and must be calculated by a plan actuary.

While there is no fixed annual contribution limit for a cash balance plan, there are two limits to be aware:

Payout limit

If a participant choose to take payments in the form of annuities, there is a limit on how much can be paid out. In 2023, the limit is the lesser of $265,000 (annually adjusted for inflation) or 100% of the participant’s average compensation for their highest 3 consecutive calendar years.

Lifetime balance limit

The maximum amount that is allowed to be accumulated in a cash balance plan is $3.4 million for 2023, which is annually adjusted for inflation by the IRS. The $3.4 million lifetime limit is a combination of principal (total contributions) and interest (annual “fixed interest credits”).

The older you are (and the higher your compensation), the more you can put into a cash balance plan per year since you’re closer to the retirement age and need to contribute more in order to reach your target amount. The contribution limit is also adjusted based on income levels.

That being said, annual contributions are typically in the range of $100,000 to $300,000 per year, depending on your age and compensation.

Contribution deadline

Contributions to a cash balance plan must be made by the business’ tax filing deadline, including extensions. For example, if you’re a sole proprietorship and file taxes by the federal tax deadline, you would have until April 15th, or October 15th with an extension.

Combine a cash balance plan with a 401k or solo 401k plan

Most business owners who adopt a cash balance plan choose to combine it with other retirement plans they may already be contributing to, such as a 401k or solo 401k.

Having a 401k or solo 401k + cash balance plan combo can allow business owners to raise their contribution limits even further. In addition to the employer contributions to their cash balance plan, they would also have the option to contribute up to $22,500 ($30,000 if age 50+) in employee contributions to their 401k or solo 401k for 2023.

However, it’s important to note that the employer contributions to the 401k or solo 401k would be reduced from 25% of compensation (~20% if self-employed) to just 6% of compensation.

What if I have employees?

Cash balance plans are best suited for self-employed people or smaller companies with few employees due to the employee contribution requirements detailed below.

Employee eligibility

As the business owner, you can choose to exclude any employees from the plan who do not meet the following eligibility rules:

Participation in the cash balance plan does not need to be offered to every eligible employee at the company. However, the employer is required to provide a “meaningful” benefit to the lesser of:

This is where it may make sense to offer a cash balance plan on top of a 401k plan to satisfy nondiscrimination testing requirements.

How employee contributions are structured

Employees are promised a specific balance by a specific date (usually by age 62 to 65). Their accounts are credited each year with a pay credit (a percentage of their compensation) and an interest credit (a fixed rate or a variable rate linked to an index such as the one-year treasury bill rate), which grows to meet the balance promised to them. Upon retirement, employees can choose to withdraw or rollover the funds in a lump sum or through a monthly annuity payment.

The exact formula and calculation for contributions is complex and require an actuary.

What if a participating employee leaves the company?

Like a 401k plan, cash balance plans can be taken with an employee if they leave the company. The amount in their plan can be rolled over into an IRA or into a new 401k plan at their new company.

Investing in your plan

In a 401k plan, each participant has their own account and they make their own investments.

In a cash balance plan, instead of each participant having their own investment account, the assets are invested in a pooled trust that each participant has a piece of. It’s maintained in the name of the plan and managed by an actuary.

The employer bears the risk of gains and losses in the account and must pay out the promised interest credit even if the investments lose money. Therefore, the investments in cash balance plans are managed in a conservative manner to avoid volatility.

This means that if the cash balance plan underperforms the assumed rate in a given year, it could require a larger employer contribution to make up for the insufficient funds to pay employee benefits. On the other hand, if the investments over perform the assumed rate, it could lower the contribution amount needed.

Costs of running a cash balance plan

A cash balance plan can cost between $2,000 to $3,000 in startup costs with ongoing annual costs of around $3,000 for plans with four to five participants. If you have employees, there are additional costs to make contributions into their accounts.

However, for businesses where a cash balance plan makes sense, a few thousand dollars per year in additional costs could open up tax savings of close to $100,000.

Every plan design is different and requires running your own cost benefit analysis in order to check if a cash balance plan makes sense for your business. 

Here are some important considerations.

How long do I need to have the plan in place for?

Cash balance plans are considered perpetual, so you should plan to operate the plan for at least 3 years..