Cash balance plans aren’t as common as other retirement offerings, but they offer some advantages worth considering for small businesses. Unlike defined contribution plans such as 401(k) and IRAs, a cash balance plan is an employer-funded program, and it does offer participants an annuity option. In addition, unlike most defined benefit plans, these programs incorporate a separate account for each employee, and the benefit can be taken as a lump sum when the employee leaves the company. (it’s important to note that in contrast to a traditional pension, a cash balance plan doesn’t provide a proportionately more significant benefit to workers with longer tenure.)
Looking at the comparison between a defined benefit plan and a defined contribution plan makes the difference clear: a defined benefit program offers an employee a specific level of income during retirement (or a lump sum of a particular amount at retirement age, but the choice must be available for the employee to choose ongoing income.) In contrast, a defined contribution program consists of specific amounts of money (typically a percentage of compensation and usually matches of individual contributions) put into an account to grow until retirement. The dollar amount available for the employee in retirement depends on the performance of the invested funds. Other factors have a potential impact, including reductions in the employee’s contributions, plus any loans or withdrawals taken against the balance.
According to the Bureau of Labor Statistics, a cash balance plan grants each employee a percentage of their annual income plus a specific investment return. The employee can calculate the amount that would be available as a lump sum using the number of years, the percentage of pay, and the return guaranteed. With a traditional defined benefit program, the employee’s final compensation has an outsize impact on the payment amount. In contrast, using a cash balance formula, the benefit is calculated by pay averaged over the years of service. The result is that these plans offer an advantage to younger, more mobile workers who change jobs more frequently.
Forbes reported recently that cash balance pension programs are growing in popularity with both self-employed and small business owners for several reasons. First, establishing the program can help manage taxes. Second, for high-income business owners, a cash balance plan can help jumpstart retirement savings for those who have waited longer than is ideal.
Depending on the income and age of the business owner or employee, contributions can possibly reach millions in 2021, although those levels are very unusual. Since the employer is stating a defined benefit, a better than expected return on the investment can allow for lower contributions later. In contrast, a shortfall in performance will mean that the plan owner (the employer) will need to make up the difference. Those additional contributions are tax-deductible and can be spread out over several years.
Forbes cautioned that these employee benefit plans are not as simple to establish or administer as other options, like a 401(k) or SEP IRA. So talk to your Taylor Benefits Insurance representative to ensure that you get expert advice before starting.
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