A pension plan is a plan to contribute funds to a retirement account that will pay you income when you are retired. Contributions to this retirement account are made by you and/or your employer during your working career.
Not all employers offer pension plans, but for those that do, there are essentially two basic varieties
- Defined Contribution Plans, which include 401k Plans; and
- Defined Benefit Plans, which include Cash Balance Plans.
Cash Balance Plans vs. 401k Plans
Cash balance plans and 401k plans are similar in the following ways:
- Contributions are tax-deferred in both;
- Your assets are protected from creditors in the case of bankruptcy or a lawsuit; and
- In both plans, you have your own account balance that is portable.
The key differences between a cash balance plan and a 401k plan are as follows:
- With a 401k plan, you choose the contribution amount and it’s very flexible. On the other hand, the contributions to a cash balance plan are set by your employer and are generally less flexible.
- With a 401k plan, you control your own account and select your investments from a menu typically offered by your employer. But, with a cash balance plan, assets are pooled and invested collectively, but by your employer.
- A 401k plan’s growth is determined by the performance of the investment you choose, while with a cash balance, your account grows with an annual interest credit set by your employer, typically between 4 and 5%.
Growth in the Popularity of Cash Balance Plans
Thanks to favorable legislation, cash balance plans have become more similar to 401k plans. They are increasingly more flexible and offer many more investment options.
In fact, most cash balance plans are paired with an existing 401k plan. The two plans, then, work together like one big 401k plan. This is sometimes referred to as “supersizing” your 401k plan.
For example, if you participate in a 401k plan, you can contribute up to $19,500 annually. And, if you are 50 years old or older, you can contribute up to $26,000 per year to your 401k plan.
If you want to save more for retirement every year, you may be able to pair your 401k with a profit-sharing plan. This can allow you to increase the annual contribution you make towards your requirements saving to $63,500 per year.
But, if you really want to save more for your retirement every year and save even more on taxes, you can use a cash balance plan, which can allow you to contribute $200,000+ towards your retirement each year.
Cash Balance Plan Advantages & Disadvantages
A cash value plan is a pension plan that looks like a 401k plan, but with a couple of twists:
- The investment rate of return is guaranteed by the employer; and,
- The employer contributions can be a great deal larger than with a 401k plan.
A cash balance plan can enable an individual with a high income to significantly lower their tax bill, and save a lot for retirement in a relatively short period of time. But, cash balance plans are not for everybody.
Unlike profit-sharing plans with discretionary contributions, the annual contributions to a cash balance plan are mandatory. This favors high-earning professionals, such as doctors, lawyers, and other high-income earners, as well as, small business owners with incomes that are predictable from year to year.
But, these individuals must have the cash flow to fund their cash balance plans on a consistent basis. Likewise, a business must be able and willing to consistently make cash balance contributions for its other employees.
Cash balance plans are increasingly popular and offer some attractive advantages. However, they are not right for everyone. For more information or for help with deciding if a cash balance plan is right for you or your business, contact us to arrange a free consultation. For help getting started with your this or your estate plan, contact us or sign up below for one of our events.