Cash balance plans are a type of defined benefit plan where the benefit payable from the plan is expressed as hypothetical account balance. They differ from a traditional defined benefit plan where the benefit is expressed as a life annuity. The value of the hypothetical account balance is defined by a formula that is specified by the plan document. Cash balance plans have become increasingly popular over recent years, especially for small business owners looking to make significant retirement plan contributions. Typically, a cash balance plan is paired with a 401(k) profit sharing plan to create an optimized retirement program for small businesses or self-employed individuals.

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The cash balance plan benefit formula spells out both 1) an annual “principal credit” and 2) and interest crediting rate. Principal credits and interest credits accumulate to a participant’s current account balance, which represents the distribution that can be taken from the plan. The principal credit can be defined in many ways – typically it will be one of the following:

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• Fixed dollar amounts (e.g. $100,000 per year)

• Percentage of compensation (e.g. 50% of annual compensation)

• “Maximum credit” designed to provide a benefit up to the limits prescribed by the IRS.

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Similarly, the interest crediting rate will be specified in the plan document as one of the following alternatives:

• A fixed rate (e.g. 5% per year)

• A variable rate equal to the rate of return on plan assets

• A variable rate equal to some other market rate (e.g. 30-yr treasury rates)

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Since the cash balance plan is a type of defined benefit plan, an actuary determines the range of acceptable employer contributions each year. Those contributions are invested in a trust (typically a brokerage account), where the plan sponsor and their financial advisor invest the assets as they wish. Benefits are usually distributed as a single lump sum, which can be rolled over tax free to another tax qualified plan, but annuity options must also be provided.

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Maximum contributions to the plan are smaller at younger ages and larger at older ages. For example, the maximum initial contribution to a cash balance plan by age is shown below:

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For comparison, defined contribution plan (such as a 401(k), profit sharing or SEP-IRA), allows a maximum contribution $66,000 per year regardless of age.