Defined Benefit and Cash Balance Plans

Defined Benefit Plans and Cash Balance Plans are both qualified retirement plans under Section 401(a) of the Internal Revenue Code. Being “qualified” means contributions are tax deductible and assets grow tax deferred while they are in the plan’s trust. Even once assets are distributed to the participant, there is an option to roll over that distribution, tax free, to an IRA or 401(k) Profit Sharing Plan, further deferring taxation.

Since contributions to these plans are tax deductions for the sponsoring entity or sole proprietorship, significant tax savings are realized in the very first year the plan is adopted. For instance, a $100,000 Defined Benefit Plan or Cash Balance Plan contribution would immediately save $35,000 in federal taxes for someone who is in the 35% federal tax bracket. The tax savings would be even higher for those living in states with an income tax. Then, that $100,000 Defined Benefit Plan or Cash Balance Plan contribution grows tax deferred as an investment in the plan’s qualified trust. Compare this to the growth of an after-tax contribution to a regular brokerage account of only $65,000 that is also taxed each year for earned dividends, interest, and realized capital gains.

Not even considering that the after-tax rate of return on the $65,000 after-tax contribution is likely less than the pre-tax rate of return on the $100,000 Defined Benefit Plan or Cash Balance Plan contribution, the $65,000 investment at a 5% increase over 30 years yields $280,926. The $100,000 Defined Benefit Plan or Cash Balance Plan contribution at 5% over 30 years yields $432,194. That being said, the assets in a qualified plan or account are eventually taxed when they are distributed directly to the participant or beneficiary. So part of considering the tax consequences of contributing to a qualified retirement plan is evaluating your future tax situation. Ultimately, we suggest discussing your individual tax and financial situation with a qualified accountant and financial advisor.

Defined Benefit Plans and Cash Balance Plans are both qualified retirement plans. In this sense, they are the same type of plan as a 401(k) Profit Sharing Plan. By satisfying the provisions of Section 401(a) of the Internal Revenue Code, these qualified plans provide certain tax deferrals, tax deductions, and creditor protections.

The methodology of Defined Benefit Plans and Cash Balance Plans is a little different than that of a 401(k) Profit Sharing Plan. For a 401(k) Profit Sharing Plan, the plan’s document defines the contributions that may be made to the plan’s participants in a plan year. That is why this type of plan is often referred to as a “defined contribution plan,” since the contribution is defined in the document. The ultimate benefits to the participants are then based on those contributions and asset performance.

On the other hand, both Defined Benefit Plans and Cash Balance Plans define the benefit that a participant is entitled to ultimately receive. Defined Benefit Plans define this as an annuity benefit that is converted to a lump sum amount. Cash Balance Plans define this as an annual contribution credit and interest credit for the participant. Then the annual funding for the plan is made to a pooled trust account according to the benefit earned in the year and the plan’s asset performance. Since a benefit is typically earned each year, a contribution is generally required each year. That being said, there is some flexibility in annual contributions because the IRS provides a methodology for the plan’s actuary to calculate a minimum required contribution and a maximum deductible contribution for the year. The plan sponsor then chooses what to fund for the year within that range.

One significant difference between a defined contribution type of plan and a defined benefit type of plan is that there is a lifetime benefit limit for defined benefit plans. Accordingly, it is possible to fully fund a defined benefit plan for your maximum benefit limit. It does take at least 10 years to earn that maximum benefit limit. At that point the plan can be terminated and assets can be moved over to a 401(k) Profit Sharing Plan or an IRA. This is done without receipt of taxable income to the participant since the assets are “rolled over” in a lump sum benefit to the receiving qualified plan or account in a qualified rollover distribution.

Generally, for sole proprietors and owner-only corporations a Defined Benefit Plan is the most effective option for maximizing your tax savings and retirement benefits. In situations where there are non-owner employees, a Cash Balance Plan paired with a 401(k) Profit Sharing Plan is likely the most cost effective way to maximize benefits for the owner or owners, while also satisfying the applicable provisions of IRC Section 401(a) related to nondiscrimination requirements and minimum benefits for eligible employees.

Yes, sponsors of Defined Benefit Plans and Cash Balance Plans generally choose to provide lump sum payout options. In fact, nearly all new Defined Benefit Plans and Cash Balance Plans utilize this option extensively. Instead of receiving an annuity type of benefit, owners of the companies sponsoring these plans use the plans to lower taxes and accumulate significant tax-deferred retirement savings. Then, once the plan is no longer needed to accrue retirement benefits it can be terminated. Assets for the owner are moved to a 401(k) Profit Sharing Plan or IRA as part of the plan’s termination. At this point the assets continue to grow tax deferred in the 401(k) Profit Sharing Plan or IRA until they are distributed directly to the participant or beneficiary.

Yes. In fact, many of TRPC’s current Defined Benefit Plan and Cash Balance Plan sponsors also have a 401(k) Profit Sharing Plan. In some cases this is purely to add additional retirement savings for owners of the plan sponsor. In situations where there are non-owner employees, a 401(k) Profit Sharing Plan is also used for purposes of passing IRC 401(a) nondiscrimination testing.

When sole proprietors or owner-only corporations are sponsoring a Defined Benefit Plan or Cash Balance Plan, a 401(k) Profit Sharing Plan is an option to lower taxes and accelerate retirement savings to even higher levels than a standalone plan provides. We can maximize the Defined Benefit Plan or Cash Balance Plan while also maximizing deferrals in the 401(k) Profit Sharing Plan, with up to a 6% profit sharing benefit. For some plan sponsors this could result in up to $40,200 in annual 401(k) Profit Sharing Plan contributions in 2017, in addition to the Defined Benefit Plan or Cash Balance Plan contributions. Corporations with non-owner employees may be able to increase the 401(k) Profit Sharing Plan benefits for owners up to the $60,000 level for 2017.

When a plan sponsor has non-owner employees, a 401(k) Profit Sharing Plan is used with a Cash Balance Plan to pass the nondiscrimination and minimum benefit requirements of IRC Section 401(a) for the eligible non-owner employees. This is the most cost effective way to provide significant retirement benefits to owners of the plan sponsor while maintaining the plan’s qualified status. It typically involves a 5% to 7.5% profit sharing contribution to eligible non-owner employees in the 401(k) Profit Sharing Plan. In these situations owners typically receive 70+% of the overall benefits in the retirement plans, and these results can be even better depending on plan demographics.

TRPC offers full-service administration for Defined Benefit Plans and Cash Balance Plans, including new plan startup. Like 401(k) Profit Sharing Plans, Defined Benefit Plans and Cash Balance Plans require plan documents that detail the provisions of the plan – eligibility, benefits, distributions, etc. TRPC works with the plan’s sponsoring employer to determine the best plan design, and then provides all necessary materials to adopt the plan. If a plan is adopted by the end of the year, then it can be effective retroactively to the beginning of the year. That means lower taxes and increased retirement savings for that year. To complete the annual administration for the plan’s initial year and in all future years, TRPC receives census and plan asset information from the sponsor so annual contributions and benefits can be calculated.