What Is a Cash Balance Plan? How Does a Cash Balance Plan Work?

This article has been updated for 2024.

What Is a Cash Balance Plan?

A Cash Balance Plan is a type of retirement plan.

However, unlike individual retirement vehicles, such as IRAs, Cash Balance Plans are employer-sponsored. Thus, an individual cannot adopt a Cash Balance Plan unless he or she is self-employed. Additionally, if an individual owns a business, the entity may adopt a Plan with the owner as a participating employee.

Cash Balance Plans are Defined Benefit Plans. They are not Defined Contribution Plans (e.g., 401(k) Plans, Profit Sharing Plans, SEPs). In a Defined Benefit Plan, benefits are formulaic and specified in the Plan document. Ultimately, the employer is responsible for funding and paying promised benefits. Thus, the employer generally must make annual contributions to fund expected increases in employee retirement benefits and adjust for Plan asset returns and changes in interest rates.

Cash Balance Plans are “Hybrid” Plans

Cash Balance Plans are “hybrid” Plans. Although they are Defined Benefit Plans, they have some Defined Contribution features.

For example, Cash Balance benefits are account-based. Like a 401(k) Plan, each employee’s benefit is based on an account balance. Conversely, Traditional Defined Benefit Plans are defined as lifetime monthly benefits (like Social Security).

Although Cash Balance Plans are account-based, each employee does not have their own account. Rather, the balances are tracked “on paper” but funded using a pooled Plan asset account.

How Does a Cash Balance Plan Work?

A Cash Balance benefit consists of two elements: a pay credit and an interest credit.

A pay credit is the amount credited to the employee’s notional account. Pay credits can be a fixed dollar amount (e.g., $200,000 per year) or a percentage of pay (e.g., 50% of compensation).

Interest credits provide the “return” on the existing balances (prior pay and interest credits). The Plan may credit interest based on a fixed percentage (e.g., 5% per year), an index (e.g., Treasury bonds), or the return on Plan assets. Interest often is credited annually but may be credited more frequently.

The table below illustrates how a Cash Balance benefit accumulates. In this example, the employer is paying an annual pay credit of $200,000 and an interest credit of 5% at the end of each year.

Year	Pay Credit	Interest Credit	Ending Balance
1	$200,000	$0	$200,000
2	$200,000	$10,000	$410,000
3	$200,000	$20,500	$630,500
4	$200,000	$31,525	$862,025
5	$200,000	$43,101	$1,105,126

As long as the employee remains with the employer, he or she will receive pay credits (unless the Plan is amended to curtail future pay credits). Should the employee leave the employer, pay credits no longer would be provided. However, the employer must credit the balance with interest until the benefit is paid.

Cash Balance Plan Advantages

A Cash Balance Plan is a powerful retirement and tax-planning vehicle for the self-employed and small business owner. For example, adopting a Plan may provide an employer with the following advantages:

• Cash Balance Plan contributions are deductible to the employer.
• Cash Balance Plans may allow much higher deductible contributions than other retirement vehicles. For example, SEPs and 401(k) Plans limit employer contributions to $69,000 and $76,500, respectively, per person. On the other hand, under the right circumstances, an employer may deduct several hundred thousand dollars per person per year in a Cash Balance Plan.
• Employer contributions made on behalf of employees are not immediately taxable to the employees benefiting in the Plan.
• Realized investment gains to Plan assets are never taxable to the employer and not immediately taxable to employees benefiting in the Plan.
• Employees may rollover their Cash Balance payouts to an IRA to continue to defer taxation of their benefit.
• Employer deductions in a Cash Balance Plan are not limited to 25% of compensation like Defined Contribution Plans (i.e., SEPs and 401(k) Plans). Thus, Cash Balance Plans often provides a higher deduction relative to a given level of payroll tax when compared to Defined Contribution Plans.
• Lump sum payouts are not interest-rate sensitive like Traditional Defined Benefit Plans.

Disadvantages of a Cash Balance Plan

With so many advantages, why would an employer not adopt a Cash Balance Plan? Here are the disadvantages of a Cash Balance Plan:

• Cash Balance Plans require more commitment than 401(k) Plans or SEPs. Generally, the employer must make an annual contribution to meet funding requirements. However, the risk of a funding deficiency can be managed by making excess contributions when possible, prudently investing Plan assets, and by funding the Plan earlier in the year.
• Cash Balance administrative costs typically are higher than annual costs for SEPs and 401(k) Plans. However, the additional tax savings far exceed the higher cost.
• For younger business owners, the investment allocation needed to minimize contribution volatility may be more conservative than is preferred. However, depending on the business owner’s situation, contributing more at a younger age than other vehicles permit provides compounded returns on a larger asset base.

Do I Have to Cover Employees?

In general, yes, the employer must cover at least a portion of its employees. The IRS has provided guidelines around minimum participation, minimum coverage and nondiscrimination testing. These rules are complicated, but a competent Defined Benefit actuary can design the Plan such that the employer objectives are met while satisfying these requirements.

Is There a Waiting Period for Employees to Participate?

Yes, the employer may require employees to work at least 1,000 hours over a one-year period before participating in the Plan. The employer also may impose a minimum age requirement of up to 21 years old.

Even after employees have met the minimum age and service requirement, the Plan may further delay entry until the next January or July 1st (for a calendar year Plan). Thus, the waiting period for a full-time employee may be as long as 12 to 18 months, depending on the employee’s hire date.

Note that, alternatively, the employer may require employees to work at least 1,000 hours for two years. However, employees would need to immediately vest in their benefits after entering the Plan. More on vesting in the next section.

Are Employee Balances Vested Immediately?

Generally, no.

The employer may require an employee to work at least 1,000 hours in three years before becoming vested. Additionally, service prior to the Plan adoption or before the employee is 18 years old may be excluded.

Note that, as mentioned above, immediate vesting is required if the employer extends the eligibility period (i.e., waiting period) from one to two years. Additionally, the employee is immediately vested at the Plan’s retirement age, which generally is age 62 or 65, and upon termination of the Plan.

In some cases, the Plan will provide immediate vesting upon the employee’s death or disablement.

Does Everyone Have to Receive the Same Formula?

No, the employer can specify different pay and interest credits in the Plan document. For example, the employer may provide different formulas for hourly and salary workers, for employees at different locations, for different positions, and even for owners and non-owners.

However, because Cash Balance Plans are tax-advantaged, the coverage of employees and the allocation of benefits must pass IRS requirements. In general, these guidelines reduce the disparity between highly compensated employees (owners and highly paid employees) and everyone else.

Can I Change the Cash Balance Plan Formula?

Yes, employers may change pay credits prospectively by amending the Plan document. However, they cannot cutback existing balances. Additionally, the interest crediting basis cannot be changed without grandfathering the current basis.

How Is a Cash Balance Plan Taxed?

Cash Balance Plans are taxed like an employer match in a 401(k) Plan. This article provides more detail.

Is the Deduction Limited to 25% of Compensation?

No. Although the individual payout limit is a function of Plan compensation, employer contributions are not limited to 25% of Plan compensation. In fact, in small Cash Balance Plans, it’s not uncommon for the permissible contribution to approach, or even exceed, current compensation.

How Do Cash Balance Plans Differ from 401(k) Plans?

A 401(k) Plan is a Defined Contribution Plan. In these types of Plans, the amount available to the employee at retirement depends on how much is contributed, when contributions are made, and the investment returns on the contributions. There is no guarantee of what those contributions will be worth in the future.

Conversely, a Cash Balance Plan is a Defined Benefit Plan. In a Defined Benefit Plan, the employer specifies the benefit up-front then must meet the projected obligation through employer contributions and investment returns. Because Plan assets and the interest rates used to value the obligation are variable, the permissible contribution range is recalibrated each year.

Additionally, Cash Balance Plans have much higher limits than 401(k) Plans. Specifically, the annual limit for a 401(k) Plan is $76,500 per year, while the Cash Balance limit can be as high as several hundred thousand dollars per year.

How Does a Cash Balance Plan Differ from a Traditional Defined Benefit?

Both Cash Balance Plans and Traditional Defined Benefit Plans are types of Defined Benefit Plans.

In many respects, small employers can achieve similar results with either type of arrangement. However, there are differences:

• Cash Balance Plans are easier to understand and value. The value of a Cash Balance benefit is simply the account balance. Conversely, in a Traditional Plan, employees can’t quantify the value of $X per month payable for life starting at age 62.
• Cash Balance single sum payouts generally are not interest-rate sensitive. The payout is simply the account balance. However, in a Traditional Plan, a single sum payout is the actuarial present value of the lifetime stream of monthly payments. The interest rates at the time of payout have a significant impact on single-sum payments. This can make lump sum payouts much more expensive when interest rates are low.
• Cash Balance Plans make it easier to allocate benefits when the business has more than one owner.
• Traditional Plans may provide a higher maximum deductible contribution in the early years after adopting the Plan, especially when the owner’s past compensation was lower than current and expected future compensation.
• In addition to using a 3-year cliff vesting schedule (0% vesting in the first two years and 100% vesting in the third year), top heavy Traditional Plans may use a 6-year graded vesting schedule (0% vesting after one year, 20% vesting after two years,…,100% vesting after six years). Cash Balance Plans cannot use this graded vesting schedule

Can I Combine a Cash Balance Plan with Another Retirement Plan?

Yes, it is common for employers to adopt a 401(k) Plan in addition to their Cash Balance Plan. This is called a Cash Balance / 401(k) Combo Plan.

For owner-only or owner and spouse businesses, adding a 401(k) increases potential tax deductions. For businesses with non-owner employees, adopting a 401(k) Plan generally reduces the cost of passing nondiscrimination testing (i.e., lowers the cost of employee retirement benefits).

What Are the Plan Requirements?

Like other employer-sponsored retirement Plans, Cash Balance Plans require compliance with the applicable laws and regulations.

For example, Cash Balance Plans must have a written Plan document and have Plan assets held in trust. Generally, the employer must make annual contributions to the Plan. Additionally, Form 5500 generally must be filed annually.

If the business has non-owner employees, the employer also must provide its employees required disclosures, be bonded, and pass coverage and nondiscrimination requirements. Additionally, if the Plan is covered by the PBGC, the employer must submit filings and pay corresponding premiums annually.

Payout Options

In most cases, employees direct the employer to pay their account balances as a single sum distribution. However, the employer also must provide the employee with lifetime payment options.

These lifetime options generally include a monthly annuity payable for the employee’s lifetime and a spousal option that provides a benefit payable for the spouse’s lifetime should the employee die first.

The conversion between the account balance and the optional forms is done using the Plan’s definition of actuarial equivalence.

Cash Balance Plan Payout Limit

The Cash Balance payout limit is a function of both age and historical compensation. At age 62, for example, the payout can be as high as roughly $3.5 million per person! Thus, in an owner and spouse Plan, the total maximum payout may be as high as roughly $7.0 million.

This article provides a table showing how the maximum payout is adjusted by age.

Is a Cash Balance Plan Right for Me?

It is worth exploring a Cash Balance Plan if you are self-employed or own a business, are at least 35 years old, and your contribution is being limited by your existing retirement Plan.

Although there are other factors to consider, an actuary specializing in Defined Benefit and Cash Balance Plans, can help you understand if a Cash Balance Plan is right for you.

How Do I Start?

The first step is to talk with a Defined Benefit and Cash Balance Plan specialist. Typically, this will be an actuary but also could be a third party administrator who outsources the certification of its figures to an actuary.