Cash balance plans: when a 401(k) stops being enough

An owner in their fifties with a profitable company and a maxed-out 401(k) runs into the same wall every year. The plan permits a certain contribution, the owner would happily shelter three or four times that, and there is nowhere for the rest to go.

A cash balance plan is usually the answer, and it is underused because it is misunderstood.

What it actually is

Technically a cash balance plan is a defined benefit pension. To a participant it looks like an account with a balance that grows by two credits each year: a contribution credit, set as a percentage of pay or a flat dollar amount, and an interest credit at a rate written into the plan document.

That framing is why it works. Participants understand a balance. They struggle with a pension formula expressed as a monthly benefit at retirement, which is the same thing in different clothing.

Why the contribution limits are so much higher

Defined contribution plans like a 401(k) cap what goes in. Defined benefit plans work backward from a promised benefit at retirement, and the permitted contribution is whatever funds that promise. An older participant has fewer years to fund it, so the annual number is larger.

This is why age drives the math. A fifty-five-year-old owner can often contribute a multiple of what a thirty-five-year-old can, which suits the typical situation: the owner is the oldest and highest-paid person in the company.

Who it fits

• Consistently profitable businesses. The contribution is a commitment, not a discretionary bonus.
• Owners over about forty-five, where the age-based math produces a meaningful number.
• Owners already contributing the maximum to a 401(k) with profit sharing and still wanting to shelter more.
• Professional practices with a few high earners and a broader staff, where the design can weight contributions toward the owners while passing testing.
• Owners a few years from selling, who want to shelter income in their final high-income years.

What you are signing up for

The commitment is the real cost. Contributions are largely mandatory once the plan is in place, so a bad year still requires funding. Plans are expected to be maintained for a period of years rather than opened and closed opportunistically, and shutting one down early invites scrutiny.

There is also employee cost. A cash balance plan generally has to cover staff, not only owners, and that contribution is a genuine expense. The design work is about finding a structure that passes testing while keeping the staff cost predictable.

And there is administration. These plans require an actuary, an annual valuation, and a filing. That is a real recurring cost, though small relative to the tax effect for an owner sheltering a large sum.

How the decision gets made

It is an arithmetic question, and the arithmetic is specific to your census. An actuary runs an illustration from your actual employee data: ages, salaries, tenure. That produces the owner contribution, the staff cost, and the administrative cost, and you compare the total against the tax effect.

For some owners the number is compelling. For others the staff cost eats the benefit. You cannot tell which without running it, and running it is not expensive.

Contribution limits, testing rules, and filing requirements change. Any illustration should be prepared for your business by a qualified actuary, and reviewed with your tax advisor.