A cash balance plan is a defined benefit plan that looks like a defined contribution plan. The benefit in a cash balance plan grows like an account in a defined contribution plan – each year a participant’s “hypothetical” account balance accumulates with contributions (called pay or principal credits) and interest credits. When a participant is entitled to receive a distribution, the amount is equal to the vested balance in his or her hypothetical account.
The interest credit isn’t necessarily tied to the actual investment return for the plan; it is specified in the plan document. The account balance never loses value so the investment risk and reward is absorbed by the employer, not the participant. For a more in-depth discussion on interest crediting rates, please click here.
Because a cash balance plan is a defined benefit plan, the contribution for a participant can be substantially larger than the maximum contribution to a defined contribution plan – depending upon the age of the participant, as much as three or four times larger.
A cash balance plan can be designed so that, unlike in a traditional defined benefit plan, key employees or business partners with the same pay and service receive the same contribution and benefit payout from the plan regardless of differences in their ages.
Cash balance plans provide a mix of the best features of defined benefit and defined contribution plans including:
Larger tax deductible contributions and therefore faster accumulation of retirement savings like a defined benefit plan, and
A more understandable and predictable benefit formula that works like a defined contribution plan.
And, a cash balance plan works well for the business owner who already sponsors a 401(k) plan. It offers the potential to substantially increase the amount the owner can set aside each year with little or no additional cost for other employees.