A self-employed Cash Balance Plan is a type of Defined Benefit Plan.
It has all the advantages of a traditional Defined Benefit Plan. For example, Cash Balance Plans allow for massive deductible contributions that grow tax-deferred and can be rolled over at retirement. In addition, self-employed Cash Balance Plans, like traditional Defined Benefit Plans, can be paired with 401(k) Plans, reduce payroll taxes and be protected from creditors.
However, unlike traditional Defined Benefit Plans that are expressed as monthly annuities, Cash Balance Plans are defined as account balances. This gives Cash Balance Plan the "look and feel" of 401(k) Plans, which can make them easier to understand than traditional Defined Benefit Plans.
At a high-level, a Cash Balance Plan consists of annual pay credits that grow at a predefined rate. Each year, a specified pay credit is given to everyone in the Cash Balance Plan. The predefined pay credits often differ among participants in the Plan. For example, owners generally receive very large pay credits and non-owner employees receive relatively small pay credits. Pay credits can be a fixed dollar amount (e.g., $200,000) or a percentage of pay (e.g., 2% of pay). Pay credits are accumulated at a predefined rate of return (e.g., 5% per year or based on a specified index). At retirement, the accumulated account balance may be paid out as a lump sum distribution.
In a Cash Balance Plan, account balances are not invested in individual accounts like a 401(k) Plan. Rather, a Cash Balance Plan is a type of Defined Benefit Plan, so benefits for each person are tracked individually, but the assets backing the individual benefits are pooled. Since account balances provide a specified rate of return, as described above, investment managers often invest assets with the predefined return rate as a benchmark. When the Plan is eventually terminated, the pooled assets and hypothetical account balances must be "trued up". This may involve the business owner making a final contribution to the Plan if account balances exceed the asset value. On the other hand, if assets exceed account balances, amending the Plan to increase account balances could be an alternative.
To learn more about how a Defined Benefit Plan can help you, see these resources:
• How much can I contribute? Defined Benefit calculator and Defined Benefit Contribution limits
• Setting up a Defined Benefit Plan: How to set up a self-employed Defined Benefit Plan
• Case Studies: Defined Benefit case studies
• Illustrator video and FAQs: Defined Benefit video and FAQs
• Defined Benefit Plans vs Cash Balance Plans: Defined Benefit Plans vs Cash Balance Plans
• Defined Benefit Plans vs SEPs or 401(k) Plans: Defined Benefit Plans vs Defined Contribution Plans
• Defined Benefit Plan rules: IRS Summary