What Is a Cash Balance Plan and How Does It Work?

Cash balance plans represent a modern approach to retirement savings, blending elements from both traditional defined benefit and defined contribution plans. They are legally classified as defined benefit plans, offering a promised benefit at retirement, but they present this benefit to employees through individual, hypothetical accounts. These plans have seen increasing adoption, particularly among business owners and high-income earners. The popularity stems from their capacity to facilitate substantial tax-deferred savings for retirement. Cash balance plans are becoming a common strategy for those seeking to maximize their retirement contributions and reduce current tax liabilities.

Defining Cash Balance Plans

A cash balance plan is recognized by the IRS as a defined benefit plan, yet its design incorporates features that resemble a defined contribution plan. Each participant receives a “hypothetical account” that grows over time. This account is an accounting record of the promised benefit, not a literal investment account.

These hypothetical accounts grow through two primary mechanisms: “pay credits” and “interest credits.” Pay credits are annual contributions made by the employer, which can be a fixed dollar amount or a percentage of the employee’s compensation. For instance, a plan might credit an employee’s account with 5% of their annual salary.

Interest credits are a guaranteed rate of return applied to the accumulated balance in the hypothetical account. This rate is defined within the plan document and can be a fixed percentage, such as 5%, or linked to a market index like the one-year Treasury bill rate. The employer assumes the investment risk, guaranteeing the interest credit regardless of the plan’s actual investment performance.

How Cash Balance Plans Operate

The operation of a cash balance plan centers on the maintenance of these hypothetical individual accounts for each participant. Annually, the employer applies the predetermined pay credits and interest credits to these accounts, increasing the participant’s accrued benefit. For example, if a plan promises a 5% pay credit and a 4% interest credit, an employee earning $100,000 would see their account credited with $5,000 in pay credit and then 4% interest on their accumulated balance.

The employer carries the responsibility for funding the plan sufficiently to meet all promised benefits. This means if the plan’s investments underperform, the employer must contribute additional funds to cover any shortfall and ensure the guaranteed interest credits are met. Conversely, if investments yield returns higher than the guaranteed interest rate, the excess gains accrue to the employer, potentially reducing future contribution requirements.

An actuary plays a role in the ongoing operation of a cash balance plan. Each year, an actuarial valuation is performed to determine the plan’s funding status and calculate the minimum and maximum contribution requirements for the employer. This ensures the plan remains financially sound. The employer’s annual contribution must be deposited no later than their tax filing deadline, including extensions.

Distinguishing Cash Balance Plans

Cash balance plans differ from other retirement options in their structure and risk allocation. When compared to traditional defined benefit plans, the primary distinction lies in how the benefit is presented. Traditional defined benefit plans typically promise a specific monthly annuity payment at retirement, often based on factors like salary and years of service. In contrast, cash balance plans express the benefit as a transparent, portable hypothetical account balance, which can often be taken as a lump sum upon termination or retirement. The individual account presentation of a cash balance plan can also be easier for employees to understand.

Compared to defined contribution plans, such as a 401(k), a fundamental difference is who bears the investment risk. In a 401(k), the employee chooses investments and bears the risk of market fluctuations, meaning their retirement benefit depends on investment performance. With a cash balance plan, the employer assumes all investment risk, guaranteeing the interest credit regardless of market returns.

Cash balance plans also generally offer significantly higher contribution limits than 401(k) plans. For instance, while a 401(k) might have a maximum contribution limit of $70,000 for 2025 ($77,500 for those age 50 or older), a cash balance plan can allow contributions as high as $403,000, depending on age and income. This makes them attractive for individuals seeking to accelerate their tax-deferred savings beyond typical 401(k) limits. Many businesses combine a cash balance plan with a 401(k) to maximize overall contributions.

Suitability and Key Considerations

Cash balance plans are particularly well-suited for business owners, partners in professional service firms like medical practices or law offices, and other high-income earners. These individuals often seek to significantly increase their retirement savings beyond the limits of other qualified plans. The ability to make substantial tax-deductible contributions, potentially hundreds of thousands of dollars annually, makes these plans a powerful tool for tax planning and wealth accumulation.

For example, a business owner earning $500,000 might contribute $150,000 to a cash balance plan, directly reducing their taxable income. The contributions are tax-deferred, meaning taxes are not paid until retirement distributions begin. While offering considerable advantages, these plans involve administrative complexity and ongoing compliance obligations.

The requirements include obtaining annual actuarial certifications, filing detailed Form 5500 with the IRS, and adhering to strict funding deadlines. These administrative tasks and the need for specialized expertise, such as enrolled actuaries, mean that cash balance plans typically incur higher setup and ongoing administration costs compared to simpler retirement plans. Employers considering a cash balance plan should have consistent, strong cash flow to meet the annual funding commitments, which can fluctuate based on investment performance.