What Is a Cash Balance Plan for 401(k)?

Retirement planning involves navigating various employer-sponsored options, each with distinct features and benefits. Understanding these approaches is important for informed decisions. Among these, a cash balance plan offers a unique approach to accumulating retirement wealth, designed to provide a predetermined benefit to participants.

Understanding Cash Balance Plans

A cash balance plan is a defined benefit pension plan that incorporates elements resembling a defined contribution plan. This hybrid offers a guaranteed retirement benefit, presented as a “hypothetical account” for each participant. This account tracks accrued benefits rather than holding actual invested assets.

The hypothetical account grows through “pay credits” and “interest credits.” Pay credits are annual employer contributions, often calculated as a percentage of an employee’s compensation or a fixed dollar amount. These credits are determined by the plan document and can vary by factors like age or length of service.

Interest credits are added to the hypothetical account balance, simulating investment growth. This credit is based on a set rate, which can be fixed or variable, linked to an external index. This interest credit is guaranteed by the employer and does not directly reflect the actual investment performance of the plan’s underlying assets.

The employer bears all investment risk. If investments perform poorly, the employer makes up any shortfall to ensure promised interest credits. This provides participants with a predictable and secure benefit, as their account balance is not subject to market fluctuations. Funds grow on a tax-deferred basis, with taxes due only upon distribution.

Key Features of Cash Balance Plans

Cash balance plans are employer-funded, with contributions made directly by the company. The amount is determined by the plan’s specific formula, calculating pay credits for each participant as a percentage of compensation or a flat dollar amount. This employer-only funding differentiates it from plans where employees contribute from their paychecks.

The interest crediting rate is a guaranteed rate specified within the plan. This rate can be a fixed percentage or tied to an external market index. The employer guarantees this return, shielding participants from investment losses. If the plan’s actual investments earn more than the guaranteed rate, the excess can reduce future employer contributions, but the participant’s credited interest remains unchanged.

Vesting determines when an employee gains full ownership of accrued benefits. Federal law generally requires participants to be 100% vested after three years of service. This “cliff vesting” means the entire accrued benefit becomes fully owned upon reaching the three-year mark. Any non-vested amounts may be forfeited if employment terminates before meeting vesting requirements.

Benefit growth in a cash balance plan is predictable and steady. Each year, pay credits and guaranteed interest credits are added to the hypothetical account, steadily increasing the balance. This consistent growth model ensures participants can project their future retirement benefit with certainty. The employer assumes responsibility for ensuring sufficient funds are available to cover these guaranteed benefits.

Cash Balance Plans and Other Retirement Options

A cash balance plan is a distinct qualified retirement plan, not to be confused with a 401(k). While both are employer-sponsored, they operate differently. A 401(k) is a defined contribution plan where the employee often contributes and the final benefit depends on investment performance. A cash balance plan is a defined benefit plan where the employer guarantees a specific benefit.

A primary distinction is investment risk. In a 401(k), the participant typically chooses investments and assumes market risk. If investments perform poorly, savings may be negatively impacted. In a cash balance plan, the employer bears all investment risk, guaranteeing interest credits regardless of market performance. This shields the employee’s account balance from market volatility.

Contribution structures also differ. In a 401(k), employees decide how much to contribute (within IRS limits), often with employer matching. For cash balance plans, contributions are made solely by the employer based on a predetermined formula; employees do not contribute. This employer-funded approach can lead to higher annual contributions.

Compared to traditional defined benefit plans, cash balance plans are often considered a hybrid. Traditional plans typically promise a monthly annuity at retirement, calculated based on salary and years of service. Cash balance plans, while defined benefit plans, express the benefit as a hypothetical account balance, which is more transparent. This account-based presentation makes them appear similar to defined contribution plans while retaining the employer-guaranteed benefit. Cash balance plans are generally insured by the Pension Benefit Guaranty Corporation (PBGC), providing protection for accrued benefits.

Accessing Your Cash Balance Plan Benefits

Upon retirement or separation from employment, participants typically have multiple options for accessing accrued benefits. The most common payout is a lump-sum distribution, providing the entire vested balance of their hypothetical account. This lump sum can be rolled over into an Individual Retirement Account (IRA) or, if permitted by a new employer’s plan, into another qualified retirement plan, preserving its tax-deferred status.

Alternatively, cash balance plans must offer an annuity option, providing regular payments for the participant’s lifetime. This provides a predictable income stream during retirement, beneficial for financial planning. The choice between a lump sum and an annuity depends on an individual’s financial situation, tax considerations, and preference for managing their retirement savings.

Portability is important for employees changing jobs. Since benefits are expressed as a hypothetical account balance, the vested balance can be rolled over into an IRA, even if a new employer does not offer a similar plan. This allows employees to maintain retirement savings with career changes. Access to funds is limited to distributable events such as retirement, termination, death, disability, or reaching age 59½.