Before we can really discuss what a Cash Balance Plan is, it’s important to have some general background information to put the discussion in context. A defined contribution (DC) plan, such as a 401(k) profit sharing plan, dictates the contributions that go into the plan each year. Contributions, which are usually discretionary, include employee salary deferrals, employer matching contributions and employer profit sharing contributions. The maximum amount a participant can receive in a DC plan each year is $49,000 for those under age 50 and $54,500 for those age 50 or older. These contributions and the investment returns they generate determine a participant’s ultimate retirement benefit.
A defined benefit (DB) plan promises a benefit using a formula that is usually based on compensation and years of service. For example, a DB plan might provide an annual benefit equal to 1% of average compensation for each year of service. If a participant has average compensation of $65,000 over 10 years with the company, the annual benefit is equal to $6,500 ($65,000 x 1% x 10 years of service) for the rest of the participant’s life.
Rather than limiting contributions, the IRS limits the maximum annual benefit a DB plan can provide to a participant to $195,000 per year. The contribution is a function of how much is needed to fund the promised benefits. While there are a number of variables, the following table summarizes the tax-deductible contributions to fund maximum benefits for DB participants of different ages:
The employer is said to bear the investment risk because the higher the return on investment, the lower the portion of the funding that must come from the company and vice versa. To the extent a DB plan is not fully funded, contributions are generally required each year.
The next part of our series will focus on clarifying what a Cash Balance Plan is, and explaining various important elements. If you missed Part 1 of our series, you can catch up here.
If you have questions about Cash Balance Plans and if they are right for your business, the Robin Weingast Team is here to help. Please contact us and we would be happy to answer all of your questions.