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401(k) cash balance combo plan

Understanding the Combo 401(k) & Cash Balance Plan

As a tax attorney with a Master’s Degree in taxation, I can pretty much read any provision of the Internal Revenue Code and, after some additional research, understand the tax code provision fairly well.  However, when it came to learning about the combo cash balance defined benefit plan, I actually found the practice of reviewing a real life case study to be far more helpful.

Below is a real-life case example of how the combo cash balance plan would work for a small business adopting the plan in 2024.  Before we get into the numbers, I will briefly explain what a combo cash balance plan is.

In general, defined benefit plans guarantee a specific benefit at retirement to each eligible employee. A cash balance plan is the most popular type of defined benefit plan. It allows for a greater contribution limit than 401(k)/profit sharing plans (up to $376,000, depending on age, instead of $76,500 for those age 50 and older in 2024 for a 401(k) plan), and hence, providing a greater tax deduction to the business owner.

The combo cash balance plan essentially combines the benefits of the 401(k) and the cash balance defined benefit plan. The 401(k) and cash balance plans are actually two plans that are combined to pass non-discrimination testing.

Thanks to the cross-testing rules, both plans can be tested in the aggregate for non-discrimination instead of each plan individually.  This has increased the popularity of the 401(k) cash balance combo plan as it allowed far more plan design flexibility.

Sample Cash Balance/401(k) Combo

Illustration of ABC 401k and Cash Balance Defined Benefit Plan 2024
Dual testing required
NameAgeCompensationDeferralSafe HarborEmployerProfit
Sharing Total
Percent of PS Contribution inc. Deferral Cash Balance CreditPercent of CB Contribution
Owner 163285,000.0026,000.0014,115.8440,115.8480.429%289,000.0099.279%
Subtotal 285,000.0026,000.00  14,115.8440,115.8480.429%289,000.0099.279%
          
Employee 15037,725.501,131.771,539.202,670.975.355%700.000.240%
Employee 24038,354.001,150.623,329.134,479.758.982%700.000.240%
Employee 33036,870.971,106.131,504.342,610.475.234%700.000.240%
          
Subtotal 112,950.473,388.516,372.679,761.1819.571%2,100.000.721%
Total 397,950.4726,000.003,388.5120,488.5149,877.03 291,100.00 

Let’s dive into the numbers which will help highlight how the combo 401(k) cash balance plan works.  In this example, the business has one owner who is 63 years old and three employees.  The owner is at a popular age for starting a cash balance defined benefit plan since he will have met the age of retirement in five years allowing him to generate large annual tax deductions.

The following key factors are important in determining whether a combo cash balance plan is suited for your business:

  • Age of business owner: Owners between the age of fifty and sixty five are typically the best fit.
  • Size of business:  A business between 1-15 employees is often the best size business for a combo cash balance plan.  Companies bigger than that may make the employee benefit related costs of the plan too costly for the business owner.
  • Steady cash flow: The business should have steady cash flow and profits.  The reason for this is that the IRS requires that when establishing a pension plan it be permanent.  The IRS has not provided a clear definition of what “permanent” means, but most interpret it to be between 3-5 years.
  • Maximize deductions:  The business owner should be focused on maximizing annual tax deductions and generating tax deferred retirement wealth.

Once you have determined that your business is a good fit for the combo cash balance plan, the next thing is to understand how the plan works and how benefits are allocated among the business owners and employees.

I am going to go through each of the columns in the above referenced combo 401(k) cash balance plan example and explain their significance.

Age & Compensation

The name, age, and compensation of the business owner and employees are relevant in determining the amount of overall 401(k) and cash balance benefits available.  Modifying the age and compensation of the business owner and each employee will change the plan design and potential plan benefits available to the business owner and the employees.

Deferral

The deferral column provides the amount of 401(k) plan employee deferral contributions made by the owner and the employees. This money is deducted from the paycheck and is not an additional cost to the employer. For 2024, the maximum employee deferral contributions to a 401(k) plan is $23,000 or $30,500 if age 50 or older. This example does not include any employee deferral contributions because the combo plan deferral calculations are not dependent on whether employees contribute to the 401(k) plan.

Safe Harbor

The safe harbor column describes the safe harbor 401(k) plan contribution amount provided by the employer to all eligible employees.  In this case, the 3% safe harbor contribution is non-elective, meaning it is made irrespective of whether the employee participates in the plan. The safe harbor election is used by the business owner because it allows them to max out the 401(k) employee deferral contribution without having to do plan testing. The safe harbor contributions required by the employer to be made to employees under the example is essentially the cost for maxing out the owner’s 401(k) employee deferrals.  Plus, the safe harbor contributions are tax deductible to the business.

Employer Profit Sharing Contribution

Profit-sharing contributions are a way to greater maximize the benefits under the plan. When designing a combo 401(k) and cash balance plan, employer contributions are no longer discretionary to the employer. Under a cross tested allocation formula, the pension plan designer is able to pick and choose how to maximize employer contributions.  Under the 401(k) cash balance combo plan testing, there are limits on the deductibility for profit sharing contributions, therefore, it makes more sense to make higher contributions to the cash balance portion of the plan versus the 401(k) portion.

When it comes to determining the amount of employer profit sharing contributions that can be made to a combo 401(k) cash balance plan, the maximum profit-sharing contributions depends on whether the company is covered under the Pension Benefit Guaranty Corporation (“PBGC”) rules. In general, the PBGC rules cover all company adopted defined benefit plans other than:

A plan established and maintained by a “professional service employer” and that has never had more than 25 active participants since September 2, 1974. For this purpose, an organization, partnership, etc. is considered a “professional service employer” if its principal business is the performance of professional services and it is owned or controlled by one or more “professional individual,” such as doctors and lawyers.  On the other hand, a non “professional service employer” with less than 25 employees would be covered by the PBGC rules. However, owner only plans (or owner and spouse plans) are not subject to PBGC coverage.

If the PBGC rules do not apply to the combo 401(k) cash balance plan, the employer profit sharing contributions are limited to 6% of employee compensation.  Whereas, if the cash balance plan is covered by the PBGC rules, the discretionary employer profit sharing contribution can go up to 25% of compensation. Therefore, if the combo 401(k) cash balance plan is covered by the PBGC rules, the business owner can technically contribute to the plan through the 401(k) portion of the plan, however, the cash balance maximum benefits would still be the same. Note – there are costs for a plan to be covered by the PBGC rules. Under the rules, the employer must pay an annual premium to the PBGC for each participant in the plan. For 2020, the minimum premium rate is $101 per participant.

In addition, under a 401(k) combo cash balance plan, employer contributions can vary by employee so long as it satisfies the non-discrimination rules.  The amount of employer profit sharing contributions provided to the employees are based on age and wage and must be sufficient to pass the top heavy and non-discrimination tests.  In this case, employee #2 received a larger employer profit sharing contribution than employee #1.  The amount of employer contributions allocated to employees are tailored specifically to provide the most benefits to the business owner. In general, it is common to provide a higher allocation of employer contributions to younger employees since the younger employee has more years to retirement and, thus, the annual benefit provided can has more long-term value, which is important for satisfying the discrimination test.

In the above example, the employer profit sharing allocation to employee #2 was done by the plan designer to maximize the deductions to the business owner and still satisfy the discrimination testing.  However, the business owner can also decide which employee(s) should receive higher employer profit sharing contributions and so long as the allocations do not violate the plan discrimination rules they will be respected.  This is a perfect example of why it is so important to work with a good pension administration company that can design the most tax efficient and beneficial pension plan for you and your business.

Profit Sharing Totals & Percentage

These two columns indicate the total amount of employer profit-sharing contributions made to the respective participants and the percentage of overall contributions they received.  In this case you can see that the business owner received the majority of the employer contributions (over 80%).

Cash Balance Credit

The cash balance credit is the grand prize of the combo cash balance plan. The cash balance credit is an actuarially determined amount and not the actual amount of cash required to be put in to the plan by the business.  The cash balance credit kind of works like a 401(k) plan.

For example, in a cash balance plan, each participating employee is provided with a number that she will have at retirement age. Let’s assume that sum is $800,000. To get to $800,000, the plan assumes a combination of employer contributions and compound interest over time. When the employee retires, she can either take the $800,000 as a lump sum or can elect an annuity option that pays a portion of the $800,000 in regular checks.  In other words, the cash balance credit is the annual amount you are seeking to accumulate under the plan.  The number is derived from the following formula:

annual benefit = (wage x pay credit rate) + (account balance x interest credit rate)

The annual cash balance credit must be confirmed each year by an Enrolled Actuary based on IRS guidance.  Annual cash balance contributions are somewhat flexible.  For example, under the above example, an actuary estimated that the minimum required contribution is $263,979, plus interest to dates of deposit. Whereas, the estimated maximum deductible cash balance contribution is $313,831.  In other words, a business owner can contribute a minimum of $263,979 plus any safe harbor contributions and employer profit sharing contributions in order to satisfy the requirements under the plan.  However, if the investments made the by the plan did not perform as predicted, then the business owner would be required to make higher annual contributions the following year.  Many actuaries typically use a conservative 4% interest rate to get an interest credit used for the cash balance credit calculation.

Contributions to the cash balance portion of the plan must be made by the time the company files its tax return – but no later than September 15. Whereas employee deferrals under the 401(k) plan must be made by December 31.  Although, employer contributions under the 401(k) plan must be made by the time the businesses files it tax return.

Percentage of Cash Balance Contributions

This column shows the percentage of cash balance contributions allocated to the respective participant.  In this case, you can see that the business owner is receiving almost all the cash balance benefits.

Conclusion

When reviewing the above referenced example, it is important to remember that these are maximum numbers.  The combo cash balance plan can be designed to provide the business owner with lower benefits and, hence, lower financial obligations under the plan.  Please remember that under the cash balance plan, the employer is required to make these contributions for all participants and the plan should stay open at least three to five years.  In other words, the combo cash balance plan can provide incredible benefits to a business owner, but there are certain financial obligations that the business owner must understand and agree to respect.

The purpose of this article was to explain in simple terms (I tried the best I could) the powers of the combo 401(k) cash balance plan.  The good news is that you don’t have to figure out all the complex details and financial particulars. Pension Investors would take care of all plan details, including plan design, annual actuarial review and testing, as well as all IRS administration.  Best of all, the plan can be customized to satisfy the tax and retirement need of the business owner and the business.

It is clear to see why the combo cash balance plan is such an amazing tax and retirement tool for the right business owner. It can provide a business with the ability to generate enormous annual tax deductions, plus generate millions of tax-deferred retirement wealth.

To learn more about the power of a combo 401(k) and cash balance plan, please contact us at either our Hollywood location or our Orlando location and set-up a free consultation with one of our pension experts.

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