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RETIREMENT PLANNING

How to Start a Cash Balance Pension Plan
 

This increasingly popular retirement plan can help accelerate your savings and reduce your year-end tax liability.

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If you are a procrastinator when it comes to putting money aside for your retirement or if your nest egg was hit hard by the economic turmoil of the past few years, you might consider establishing a cash-balance pension plan at your company. When done properly, these plans can be a great way for small-business owners to substantially accelerate their retirement savings, while also lowering their year-end tax bill and offering a nice little perk to employees.

How to Start a Cash Balance Pension Plan: The Appeal

A cash balance pension is a qualified retirement plan under IRS guidelines known as a "hybrid" plan that's funded by an annual employer contribution.

Such plans have steadily become more popular since the passage of the Pension Protection Act of 2006, which clarified what it would take for a plan to get the IRS's blessing.

Depending on how close to retirement you are, a cash balance plan could allow you to contribute well in excess of $100,000 annually to your own retirement. That compares to a maximum of roughly $50,000 under a 401(k) plan.

"Cash balance is a great way to accelerate savings," says Daniel Kravitz, president of Kravitz, a firm in Los Angeles that designs and administers retirement plans. "We like to say you can squeeze 20 years of savings into 10."

Another major appeal of a cash balance plan is that it helps you reduce your year-end tax liability. Given the expectation that taxes will rise in the coming years, that's clearing a huge plus.

Kravitz says a rule of thumb is that if 70 percent of the money going into the plan is for the owners and executives, the tax savings for those beneficiaries far outweighs the cost of funding the accounts of rank-and-file employees and administering the plan. At 50 percent, it's typically a wash, but you still have the added plus of giving a nice perk to your employees rather than paying the money in taxes.

Dig Deeper: How to Reduce Your Small Business Tax Bill

How to Start a Cash Balance Pension Plan: How It Works

A cash balance plan has the look of a defined contribution plan, but is actually a defined benefit plan. Under a cash balance plan, as mentioned before, the employer makes an annual contribution to an employee's account. But here's a special attribute in the design of the plan: the return on the participants' assets is guaranteed. Known as the annual interest credit, the annual return is usually tied to the 30-year Treasury rate, which has been around 5 percent in recent years.

This concept is where people most commonly get confused, says Kravitz. As with other pension plans, the assets are pooled and invested by a trustee or investment manager. If the assets perform better than the benchmark return, your contribution the following year will be smaller. For example, if the annual contribution is $100,000 and the plan returns 10 percent rather than the guaranteed 5 percent, the contribution the following year will only be $95,000. Conversely, if the plan's investments fall short of the promised return, the employer has to make up the difference. That shortfall can be made up over seven years.

For this reason, the plan is usually invested rather conservatively, though Kravitz says he's seen some business owners get aggressive during bull markets only to have to make up some serious shortfalls once markets reversed.

Dig Deeper: Inc.'s 401(k) Retirement Calculator

How to Start a Cash Balance Pension Plan: Setting Up the Plan

Kravitz says that clients typically come to services like his through tax or financial advisers. The adviser will first collect an employee census that outlines the demographics of the company, such as employee ages and salaries. With that information, a plan designer calculates how much can go into the plan for executives and owners and how much will have to go in for the employees to pass IRS testing that ensures the plan's benefits don't discriminate in favor of officers, shareholders or any employees.

Step two is putting together a legal document laying out all the plan's details, including the contributions for the participants and the annual interest credit. This document must be signed no later than the end of the fiscal year for which the company wants to take the deduction.

Contributions to the plan must be funded by the due date of your tax return including extensions and no later than eight and a half months after the year ends. That means you have until September 15, 2011 to fund the plan to get the deduction for 2010, assuming you've filed for a tax extension.

A rule of thumb on fees, says Kravitz, is that it will cost twice as much to administer a cash balance plan as a 401(k) plan. Tax returns, participant account statements, and discrimination testing will be required each year. For its part, Kravitz charges a flat fee of $5,500 to set up a plan and $5,500 each year to administer it plus $115 for each participant.

Dig Deeper: Inc.'s free Employee Pension Plan Outline

How to Start a Cash Balance Pension Plan: Running the Plan

A few things you should know once the plan is up and running:

  • Once participants work 1,000 hours during a year, a plan contribution becomes required for that year. Around the middle of each year, you'll want to make sure it looks like your business will be able to make that year's contribution, or you might need to amend or freeze the plan before participants hit that threshold.
  • If you want to increase contributions for a year, you have two and a half months after the year ends to make a change.
  • Any vested account can be paid as a lump sum or annuity. The lump sum can be rolled over to another qualified retirement plan.
  • A plan can be terminated at any time. Once terminated, the plan's assets are distributed. Participants can take the distribution and pay the taxes or rollover the assets into another plan.

Dig Deeper: How to Create a Personal Financial Statement

How to Start a Cash Balance Pension Plan: Other Considerations

Sure, accelerated retirement savings and reduced tax liabilities sound good, but cash balance plans aren't for everyone. Any company offering a cash balance plan should be confident it can make its annual contribution, so a history of dependable profits is a must. While you can make changes from time to time, frequent amendments to the plan might prompt the IRS to deem it a cash-deferred arrangement and not a pension plan. In which case, regular 401(k) limits would apply.

The plan should be used in addition to a 401(k) plan, not as a substitute, Kravitz recommends. Given the cost and complexity – it does require the assistance of an actuary, after all – a cash balance plan should only be considered if a 401(k) isn't meeting your company's retirement needs. Plus, the conservative returns promised by a cash balance plan means you'll probably want the flexibility of another retirement plan you can invest more aggressively.

'This is just if you want to do more for your retirement,' says Kravitz. 'This is forced savings for many small business owners.'

Last updated: Jul 30, 2010




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