Imagine your 401(k) plan on steroids. Imagine being able to contribute four times more than your current 401(k) limit. Imagine having an balance where investments are managed for you and the investment return is guaranteed. And imagine, upon termination or retirement, taking your balance as a tax-free rollover into an IRA. Well, your imagination may turn to reality, as Cash Balance Retirement plans now provide the above advantages, while opening the door to those looking to sock away a lot more in pre-tax contributions into their ERISA protected retirement savings accounts.
According to the IRS, Cash Balance Plans are the fastest growing type of retirement plans in the United States, with over 1,000 plans being approved each year. For high-income earners and business owners, they provide much higher pre-tax contribution limits (> $200,000/year) in addition to your regular 401(k) annual contributions. These contributions fall under the full protection of ERISA against creditor claims or lawsuit damages, an important factor to owners running a business or who may be part of a profession subject to such claims. While these plans have been around since the 1980s, their increasing popularity is attributed to recent legal changes and court rulings that have provided clarity on plan administration and has offered greater flexibility in plan design for the employer.
The Motivating Factor
So, why all the interest? In a word….Taxes. It can be a great motivator, especially when it comes to giving someone the ability to reduce their own personal income taxes, and instead park that money into an ERISA-protected account. This is what gives Cash Balance plans their real appeal. Under the current tax climate where Federal, State, and Medicare tax rates are approaching a combined 50% on income, the opportunity for an individual to make larger pre-tax contributions can be a highly effective way to reduce income and avoid these higher rates. Cash Balance plans combine higher contribution limits found in traditional pension plans with the simple mechanics of a 401(k) plan. Under a Cash Balance plan, an employee has an account balance that’s easy to understand and upon termination or retirement, they can make a lump-sum, tax-free rollover distribution of that balance into a traditional IRA account.
This 401(k)-like portability allows the cash balance plan to address both the immediate need of retiring employees, as well as those needs of younger professionals who may change jobs several times throughout their career. For employers, the optimal design has the Cash Balance Plan sitting alongside their 401(k) plan, not replacing it, and thus offering a one-two punch. With this design, the individual can make pre-tax contributions into each plan, reducing their taxable income, and simultaneously accelerating their success trajectory towards reaching their retirement savings goal.
How much more could I contribute?
Currently, the maximum contribution to a 401(k) plan for a participant age 50 or older is $57,500. When combined with a cash balance plan, this pre-tax contribution limit increases to more than $250,000/year. Let’s look at a 60-year-old business owner, for example, whose maximum cash balance plan contribution could be as high as $230,000/year. With his maximum 401(k) contribution of $57,500, a total of $287,500 is contributed pre-tax to both plans, yielding over $100,000 in tax savings back to the individual.
So…what’s the catch? To achieve these higher benefits, it requires a higher level of technical expertise from the firm hired to run the plan for the employer. Appropriate plan design is
critical, which involves plan set-up time from experienced professionals to reach the optimal benefit for each individual, while maintaining plan compliance for the employer. This added expense includes hiring an enrolled actuary for plan valuations and to ensure plan compliance each year. Operationally, the biggest difference when comparing a cash balance plan to a 401(k) plan is that individuals cannot direct how to invest their balance. Instead, investments are managed for the participant by an outside investment manager selected by the company. Participants get an account statement (just like their 401(k) statement) that shows their account balance growing each year by their elected contributions plus the plan’s earnings — a rate of return specified in the plan document and guaranteed by the employer. Given this guarantee, employers will prudently select a modest return of 4% to 5% for their plan, which is manageable for the investment manager to achieve as the plan’s investment return target.
Is it worth it?
When comparing a cash balance plan’s benefits against the added costs to offer this plan, many businesses recognize it as a great way to help their high-income (and highly taxed) employees spend less each year in taxes, and save more of that money for retirement. These plans allow high-income individuals and business owners the chance to achieve considerable current tax savings and catch up on their retirement contributions, while knowing these funds won’t sit on the company’s balance sheet, but instead are held in an ERISA protected qualified trust.
The tax advantages of a Cash Balance Plan are significant for those looking for ways to pay less in taxes each year, and accelerate their retirement savings. Today’s retirement plan design landscape is changing, as the prospect of achieving a consistent double-digit return in the equity markets is not as attractive as realizing immediate tax savings offered through a Cash Balance Retirement Plan.
Richard Burke is a Principal of Burke Group, an employee benefits and compensation consulting firm based in Rochester, NY. Burke Group has provided fiduciary and administrative services, actuarial services, and executive compensation consulting to public and private employer organizations since 1989.