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What is a Cash-Balance Plan?

A cash-balance plan is a distinct type of pension plan that frames the retirement benefit as a prospective account balance instead of an income stream. It's a subcategory of defined-benefit pension plans, yet it carries the impression of a defined-contribution plan due to its individual account setup. The employer credits a participant's account with a predetermined percentage of their annual earnings and interest charges, creating a well-defined future benefit. The investment risk, funding requirements, and funding limits align with defined-benefit criteria.

Unlike a traditional pension, the cash balance plan isn't influenced by fluctuations in the investment portfolio. Instead, it's the employer that shoulders the profit or loss from investments, thereby ensuring the plan participant is not directly affected by market volatility. Hence, this unique plan structure gives employees an added level of security.

Participant Contributions and Benefit Disbursements

The mechanics of cash-balance plans differ from those of traditional pensions. In a cash-balance plan, employees technically do not contribute to the plan (unless they're owner-employees), and they have no direct control over the assets being managed on their behalf. On retirement or termination, the participant is entitled to the balance in their account, which can be taken as a lump sum or converted into an income stream.

However, as with all qualified plans, the employee will owe income taxes on any disbursed benefits. It's noteworthy that due to its nature as a defined benefit plan, a cash-balance plan can be more expensive to administer than most other plans. Costs such as actuarial fees, custodian charges, premiums to the Pension Benefit Guaranty Corporation, and accountant’s fees for filing IRS Form 5500 are part of the package.

Who Can Benefit from a Cash-Balance Plan?

Cash-balance plans can be an effective tool for businesses of all sizes if the financial circumstances align. They're especially beneficial for professional partnerships with a small workforce and high income, as these plans might enable them to defer taxes on up to $200,000 of income annually. In order to ensure fairness, these plans must pass top-heavy testing requirements, often combining with 401(k) plans to meet participation and contribution targets from lower-income employees.

The Hypothetical Account and Plan Conversion Trends

Assets in cash balance plans are pooled together, yet each participant has a personal "hypothetical" account that represents their share. This is the balance they can roll out of the plan if they switch jobs, provided they are fully vested.

An intriguing trend has emerged over recent years, with many pension plans being converted into cash-balance plans. This shift is aimed at reducing the long-term financial liabilities of employers, replacing an unpredictable lifelong income stream with a certain account balance.

The Contribution Limits and Age Factor

Cash-balance plans operate without contribution limits due to employer funding targeted to achieve a specific account balance by the employee's planned retirement date. A key benefit of these plans is that the contribution limits rise with age, making them a strategic tool for older workers seeking to boost their retirement savings.

Cash-balance plans provide a promising alternative to traditional pension plans. They offer the security of defined benefits, the individual account structure of defined contribution plans, and considerable tax advantages, all under a unique framework. The plan's design and flexibility make it a viable option for many employers and employees alike.

Summary

Cash balance plans are a type of pension in which the benefit is stated as a future account balance rather than an income stream. A Cash-Balance Plan is very similar to a normal Pension Plan. You do not technically contribute anything to the plan (unless you are an owner-employee), and you don’t have any control over the assets which are managed on your behalf.

In a normal pension, the benefit waiting for you in retirement is a monthly income stream, but in a Cash Balance plan, your future benefit is stated as an account balance, which you will be able to take as either a lump sum or an income stream.

You will owe income taxes on either one, as with all qualified plans. Since it is a Defined Benefit plan, it will cost more to administer than most other plans. You will have to pay an actuary, an investment company to act as custodian, premiums to the Pension Benefit Guaranty Corporation, and accountant’s fees for filing IRS Form 5500 (found here).

Business of any size can use these plans if it makes sense for them. Professional partnerships with few employees and high income are likely to benefit from these plans, since it may allow them to defer taxes on up to $200,000 of income a year.

The plan must pass top-heavy testing requirements, of course, and cash balance plans are often blended with 401(k)s to use the other plan to help them get enough participation and contributions from lower-income employees to pass the tests.

Plan assets are pooled together, but participants can see their balance in their own “hypothetical” account. This is the balance they can roll out of the plan if they change jobs, assuming they are fully vested.

It is also interesting that many pension plans have been converted to cash-balance plans, in an effort to relieve some of the long-term liabilities of employers by giving employees a definite account balance as opposed to an income stream for life (which is an uncertain length of time).

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Disclaimers and Limitations

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