Many firms that sponsor 401(k)’s plans have a problem. The owner(s) would like to put away as much money as possible but to do so would require large contributions for the employees. The employees enjoy the ability to defer their salary and have some sort of match but as they realized to their dismay from 2000-2 their plan assets are not guaranteed. One solution that could solve both problems is the 401(k) and Cash Balance “Combo Plan”.

What is a Cash Balance Plan?

When you think of cash balance pension plans you tend to think of IBM and other large companies that have used them to reduce their employee benefit costs. What many people do not realize is that in the right situation, these plans can provide a number of benefits to small business owners as well.

Traditionally, when a small business owner wanted to install a retirement plan for their business they had two options: Defined contribution plans like 401(k)’s, profit sharing, money purchase, SEP, SIMPLE, etc. or defined benefit plans. Defined contribution plans limit the cost of contributions for employees but also limit the tax deductible contribution for the business owner ($44,000 in 2006). Defined benefit plans allow a large contribution for the owner but can also mandate large contributions for employees. Now, cash balance offer another option, potentially large tax deductible contributions for the business owner with low contributions for employees.

Cash balance plans are a hybrid retirement plan designed to combine the best features of defined contribution and defined benefit plans. Like a defined contribution plan, employees have their own accounts with contributions based on compensation and interest which is credited each year based on a formula specified in the plan document. Like defined benefit plans, the retirement benefit is the greater of the benefit that can be provided by the employees account or a minimum benefit as described in the plan document.

Combining a 401(k) with a Cash Balance Plan

Combining an existing 401(k) plan with a Cash Balance Plan can be a way for a the business owner(s) to get large tax deductible contributions without necessitating large contributions for employees. It can also guarantee minimum retirement benefits for employees regardless of what the market does. Here is an example:

XYZ Company has 4 owners, 3 top executives, 7 family members, and 19 rank and file employees. The owners each make $220,000/yr, the executives and family members earn between $45,000/yr and $180,000/yr. XYZ currently has a 401(k) plan but would like a way for owners, top executives, and family members to put away more money without too much of a cost for employee contributions. By adding a Cash Balance Plan on top of the 401k the results were as follows:

Tax deductible contributions for the owners= $86,000/yr for each owner
Total contributions for owners, executives, and family members= $433,770/yr
Total contributions for employees= $67,646
Total plan contributions= $501,416
% of contributions that go to owners, executives, and family members= 86.51%

So in effect, the plan will save the owners approximately $200,000/yr in taxes but the cost of the employees is less than $70,000!

The employees can invest their 401(k) plan assets more aggressively knowing that they also have a Cash Balance Plan that provides a fixed benefit in retirement.

In the right situation, adding a Cash Balance Plan can help employers supercharge their 401k plans.