What Is a Cash Balance Retirement Plan?
Saving for retirement is just as important for the Early Childhood Education business owner as it is for the employer or employee in any other field. While you are probably familiar with traditional retirement plans like a 401(k), you may not know about another excellent choice for retirement savings called a cash balance plan. In the following guide, learn what a cash balance retirement plan is and whether it may be the right retirement savings plan for you.
What Is a Cash Balance Plan?
Retirement plans generally fall into one of two categories: defined contribution plans and defined benefit plans.
According to the U.S. Department of Labor, a defined contribution plan is a type of retirement plan in which the employer, employee, or both make specified contributions. 401(k) plans, 403(b) plans, employee stock ownership plans, and profit-sharing plans are all types of defined contribution plans.
A defined benefit plan is a type of pension plan which promises a specified benefit upon retirement in the form of a specified monthly payment, lump sum, or some combination thereof.
A cash balance plan is a type of defined benefit plan. This means that a cash balance plan defines the promised benefit in terms of a stated account balance. Let’s take a look at exactly how a cash balance plan works.
How Does a Cash Balance Plan Work?
In a cash balance plan, the participant’s account is credited each year with a “pay credit” and an “interest credit.”
The pay credit, as an example, might be five percent of compensation from the participant’s employer. The interest credit is typically either a fixed or variable rate that is linked to an index, such as the one-year treasury bill rate.
Increases or decreases in the value of investments in a cash balance plan do not directly affect the promised benefit amount for the retiree. Instead, the investment risks are the employer’s alone.
When the participant becomes eligible to receive the benefits from the cash balance account, they are granted the funds in terms of the promised account balance.
For example, let’s say a participant has an account balance of $300,000 at the age of 65. She would be entitled to receive the total amount either in the form of an annuity or a lump sum. If she did choose to take a lump sum, she could opt to roll over the distribution into an IRA or another employer’s plan if the plan accepts rollovers.
As with most traditional defined benefit plans, the benefits in a cash balance plan are protected within certain limits by federal insurance provided by the Pension Benefit Guarantee Corporation.
Pros and Cons of a Cash Balance Plan
As with all retirement plans, there are pros and cons to the cash balance plan. Let’s take a look at them:
- ✅ Lump Sum Payout – With a cash balance plan, the participant can opt to receive the account balance in a lump sum, which provides for other investment opportunities, like government bonds, money market funds, or rollovers to different retirement plans.
- ✅ Tax-Deferred Contributions – The contributions you make with a cash balance plan are tax-deferred, meaning you don’t need to pay taxes on the distributions until you either make withdrawals or take a lump sum payout.
- ✅ No Contribution Limit – The annual limit for a cash balance plan is determined by your age bracket, your income, and the target date and balance of the fund. With a cash balance plan, you can potentially put away a lot of money for retirement in a short amount of time.
- ❌ Expensive to Maintain – Probably the biggest downside to a cash balance account is the high cost of maintaining one. The higher cost is due to needing an actuary to ensure the account performs well enough to fulfill the balance requirements.
- ❌ Taxable Distributions – As with other retirement saving plans, you will ultimately have to pay taxes on the distributions when you withdraw the funds.
- ❌ No Employee Contributions – In a cash balance plan, only the employer makes contributions, so the employee cannot add additional money from his or her earnings.
As you can see, there are positives and negatives to using a cash balance plan as your retirement savings plan of choice.
Even though a cash balance account is expensive to maintain, it can help you put away a significant amount of money for your retirement. As such, we tell our clients it may be a good option if you are getting ready to sell your childcare center or retire in the near future, as you wouldn’t be required to pay into the account long term.
As always, we recommend discussing the best retirement plan for you with a qualified financial professional.
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