In recent years, the interest in cash balance retirement plans has grown significantly, particularly among those in the medical and legal professions. One reason for the renewed interest is that after years of examining these plans, the IRS finally gave its stamp of approval, eliminating the reluctance of some employers to establish a cash balance plan. However, the main reason for the renewed interest is the potential for certain individuals to contribute much larger dollar amounts to a cash balance plan ($100,000 + for age 55 and older) annually compared to the current $56,500 annual maximum that can be contributed to a 401(k) plan.
Older Partners/Younger Staff
In many instances, professionals in the early years of developing their practices will delay putting funds aside for retirement. Once they have established themselves and have the income to start seriously planning for retirement, the cash balance plan is a perfect vehicle to accumulate large amounts over a short period of time. Those who benefit most from a cash balance plan tend to be in professional services fields where the key employees (owners, senior management) are older than the other employees. This specific workplace demographic works well under a cash balance plan because each key employee is put into a separate class whose contributions are compared to the contributions made on behalf of the other employees, for nondiscrimination testing purposes. It is easier to demonstrate that a plan does not discriminate in favor of key employees when there are a limited number of them to make that comparison.
The Internal Revenue Code permits a plan sponsor to fund a disproportionately larger pension contribution on behalf of an older employee as a way of creating a level playing field. The reasoning is that since older employees have fewer years to accumulate a benefit at retirement age, there is a permitted disparity between the annual contributions provided to them versus those provided to younger employees.
The plan must be tested annually to make sure this disparity is within IRS guidelines. This is done by comparing each key employee's cash balance contribution with the contributions made on behalf of the other employees, by converting each individual's annual contribution to an "equivalent" benefit based on actuarial assumptions (age, mortality factors, federal rates).
How it Works
The cash balance plan is considered a hybrid plan because it has characteristics of both a profit sharing plan (defined contribution) and a traditional pension plan (defined benefit). An individual's benefit under a cash balance plan is similar to the benefit under a profit sharing plan (i.e., an account is established on behalf of each participant and that account is credited annually with a fixed contribution that can be either a percentage of pay or a flat dollar amount). The individual also receives annually a predetermined rate of return on their account, usually based on an established index (such as a 10-year treasury), applied as of the first day of the plan year. The annual contributions and rates of return are referred to in cash balance plans as pay credits and interest credits, respectively.
The defined benefit aspect of a cash balance plan is in the way it is funded. The annual amount that the plan sponsor must fund to ensure there is enough plan assets to pay each individual's promised benefit is determined based on actuarial mortality tables, established federal rates and the current value of the plan assets. The plan sponsor is provided with a funding range starting with a minimum required contribution and ending at the maximum deductible contribution limit. Typically, in the early years of the plan, plan sponsors tend to fund the plan towards the high end of the funding range because they have the means to do so. Additionally, amounts contributed above the minimum required contribution help to prefund the plan for future years.
XYZ Orthopedics consists of four physician partners whose ages range from 55 to 62. The practice employs five staff employees whose ages range from 25 to 40. The practice sponsors a cash balance plan. The partners' goal is to maximize their cash balance contributions while minimizing the cost on behalf of their employees.
Based on the doctors' current ages, the practice could contribute up to $100,000 annually on behalf of each doctor while contributing 10% of pay on behalf of their employees and comply with the IRS' nondiscrimination testing requirements.
|Cash Balance Plan|
|Pct of total (Principals)||95.12%|
|Pct of total (Staff)||4.88%|
The above example is one specific scenario. Other scenarios can be derived with varying contributions made on behalf of each doctor while maintaining the 10% contribution on behalf of the staff.
Of course with the larger contributions comes a larger commitment. The cash balance plan's specific pay credits and interest credits are determined when the plan is initially designed and are incorporated within the plan documents. These amounts are required contributions. They are not discretionary amounts that are determined on a year-by-year basis. Failure to meet the minimum funding requirement will result in an excise tax being imposed on the plan sponsor. As a rule of thumb, sponsors of cash balance plans must anticipate being able to fund the plan for at least 3 to 5 years before amending or terminating the plan. Professional services firms usually have the means to fund the plan for a 3 to 5 year minimum.
An even greater opportunity is afforded when a cash balance plan is paired with a 401(k)/profit sharing plan, giving each principal the ability to conceivably contribute, in addition to their cash balance contributions, $23,000 in 401(k) employee salary deferral contributions and to receive 6% of their earned income as an employer contribution. This scenario, which involves a more detailed analysis, may be addressed in a future article.
For any questions about the content on this article, please email James Williams at JWilliams@FriedmanLLP.com or contact your engagement partner.