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The New 401(k)

California CPA magazine: November 2007

Popularity Rising: Cash Balance Plans Can Help Reduce Taxes, Increase Savings

By Dan Kravitz

An increasing number of highly compensated individuals are finding that their contributions to 401(k) and profit sharing accounts have reached the maximum allowable amounts. Thanks to the Pension Protection Act of 2006, however, all is not lost. The act granted statutory recognition to “hybrid” retirement plans, such as cash balance plans.

Prior to the act, this plan type was not officially recognized in the tax code, though the IRS was approving it.

Given this, there have been an increasing number of companies that have adopted qualified cash balance plans, which allow for substantial increases in contribution levels and increased tax savings.

As the fastest-growing retirement plan in the United States, based on 2005 Form 5500 filings, 401(k) plans allow participants to contribute up to $20,500 for 2007, depending on the participant’s age. A profit-sharing plan allows employers to contribute an additional $29,500 on behalf of the participant.

However, once the annual maximum contribution has been reached ($50,000 for those 50 years of age and over; $45,000 for those under 50 years of age), no further contributions can be made for that participant on a pre-tax basis.

A cash balance plan contribution, however, can be as much as $200,000 per year, depending on the participant’s age. For individuals making in excess of $250,000 per year and looking for additional tax deductions, a cash balance plan provides welcome respite from the low retirement plan contribution levels available through a 401(k) profit sharing plan.

The Basics

A cash balance plan is a defined benefit plan that specifies the amount of contribution to be credited to each participant. The participant’s contribution can be either a flat dollar amount or a percentage of pay. The plan credits interest on those contributions at a guaranteed rate, which is spelled out in the plan
document and is not dependent on the plan’s investment performance. The rate changes each year and for many plans is equal to the yield on the 30-year treasury bond, which in recent years has been about 5 percent.

Each participant has an individual account that resembles the accounts in a 401(k) or profit sharing plan. The plan actuary, who generates annual participant statements, maintains the accounts. Once participants terminate employment, they are eligible to receive the vested portion of their account balance as determined by the plan’s vesting schedule.

Good Candidates

Companies that are good candidates for cash balance plans include professional service businesses, such as CPA and law firms, medical groups and family or closely held businesses where there are a number of owners who may be at or approaching their 401(k) and profit sharing contribution limit. Characteristics of such business include one or more of the following:

1. Owners who want to contribute more than $45,000 per year

Owners may neglect their personal retirement savings while they are building their businesses and consequently need to catch up on their retirement savings.

In addition, many profitable businesses need tax deductions and $45,000 is not enough. A cash balance plan allows for both an acceleration of savings and a large tax deduction.

2. Owners more than 40 years old who desire increased tax deductions or wish to catch up on their pension savings

The maximum contributions allowed in cash balance plans are age dependent. Therefore, the older the participants, the faster they can accelerate their savings.
3. Companies that have demonstrated consistent profit patterns

Because a cash balance plan is a defined benefit pension plan with required contributions, a consistent cash flow and profit is important.
4. Companies that are contributing 3 percent or more to employees’ accounts or are at least willing to do so

While cash balance plans often are established for the benefit of owners and other key employees, rank and file staff also benefit. The plan normally provides a minimum contribution of 5 percent to 7 percent of pay for the company’s staff.

Is It Right for You?

Because cash balance plans are a type of defined benefit plan, they require a commitment to a specific contribution level—a dollar amount, percent of pay or age-weighted maximum for a particular individual—from the company for two to three years. It is important that a company display consistent profit patterns to consider a plan.

One also should consider company demographics and company culture. Cash balance plans can allow for large contributions for select employees, such as owners and executives. However, some company cultures dictate that all employees are treated equally with regards to retirement plan contributions. Therefore, these plans may not be a good fit for companies that place everyone on the same level.

The advantage of cash balance plans over traditional defined benefit plans is that owners and shareholders know what is going into the plan on their behalf and what will come out when they leave. When they reduce their compensation to contribute to a retirement plan, it is imperative that they feel assured that when they leave the company what they put into the plan will come out—along with interest.

Because they are not profit sharing plans, under which contributions can vary each year depending upon profitability, cash balance plans are amended to change contribution levels. Employers can designate different contribution amounts for various participants. However, the frequency of amendments to change benefits may be restricted in the absence of a valid business reason.

For example, if a company’s profit is not expected to support the plan’s contribution, the plan can be amended. A cash balance plan also can be frozen or terminated.

Tax deductions for contributions to cash balance plans are similar to other tax qualified retirement plans. One thing to watch out for is that contributions by
a partnership to cash balance plans are allocated like other firm expenses (in proportion to ownership) unless the partnership agreement provides otherwise. Partnership agreements may need to be amended so that the contribution is allocated in proportion to each partner’s plan benefit.

Dan Kravitz is president of Kravitz (Louis Kravitz & Associates), a retirement plan consulting firm. You can reach him at dkravitz@lkravitz.com.

The following table lists the amount that individuals can contribute to a 401(k), profit sharing and cash balance plans:

    Age    401(k)     401(k) with     Cash     Total                only    Profit Sharing    Balance
65    $20,500    $50,000    $185,000    $235,000
64    $20,500    $50,000    $190,000    $240,000
63    $20,500    $50,000    $193,000    $243,000
62    $20,500    $50,000    $197,000    $247,000
61    $20,500    $50,000    $187,000    $237,000
60    $20,500    $50,000    $177,000    $227,000
59    $20,500    $50,000    $168,000    $218,000
58    $20,500    $50,000    $158,000    $208,000
57    $20,500    $50,000    $150,000    $200,000
56    $20,500    $50,000    $142,000    $192,000
55    $20,500    $50,000    $135,000    $185,000
54    $20,500    $50,000    $128,000    $178,000
53    $20,500    $50,000    $121,000    $171,000
52    $20,500    $50,000    $115,000    $165,000
51    $20,500    $50,000    $108,000    $158,000
50    $20,500    $50,000    $103,000    $153,000



    Age    401(k)     401(k) with     Cash     Total                only    Profit Sharing    Balance
    49    $15,500    $45,000    $98,000    $143,000
48    $15,500    $45,000    $93,000    $138,000
47    $15,500    $45,000    $88,000    $133,000
46    $15,500    $45,000    $84,000    $129,000
45    $15,500    $45,000    $80,000    $125,000
44    $15,500    $45,000    $75,000    $120,000
43    $15,500    $45,000    $72,000    $117,000
42    $15,500    $45,000    $68,000    $113,000
41    $15,500    $45,000    $64,000    $109,000
40    $15,500    $45,000    $61,000    $106,000
39    $15,500    $45,000    $58,000    $103,000
38    $15,500    $45,000    $55,000    $100,000
37    $15,500    $45,000    $52,000    $97,000
36    $15,500    $45,000    $49,000    $94,000
35    $15,500    $45,000    $47,000    $92,000
34    $15,500    $45,000    $44,000    $89,000