What Is a Cash Balance Plan for Small Business?

Small business owners looking to maximize retirement savings while reducing taxable income may find a cash balance plan appealing. Unlike traditional 401(k) plans, these defined benefit plans allow higher contribution limits, especially for older business owners looking to accelerate savings.

These plans combine features of pensions and 401(k)s, offering predictable retirement benefits with tax advantages. Understanding how they work can help small businesses determine if they align with long-term financial goals.

Hypothetical Account Balances

A cash balance plan provides participants with an account that grows annually through two components: a pay credit and an interest credit. The pay credit is a percentage of the employee’s salary, typically between 5% and 8%, while the interest credit is either a fixed rate or tied to an index like the 30-year Treasury bond yield. Unlike traditional pensions, this structure allows participants to track their retirement savings more transparently.

For example, an employee earning $100,000 with a 6% pay credit would receive $6,000 in contributions for that year. If the interest credit is 5%, the balance would grow accordingly. Over a decade, assuming consistent earnings and credits, the account could accumulate significantly, providing a clear projection of retirement benefits.

Mandatory Employer Contributions

Employers sponsoring a cash balance plan must make annual contributions based on the plan’s formula, determined by an actuary. These contributions are required, unlike a 401(k), where employer contributions are often optional. Since cash balance plans are defined benefit plans, the employer bears the investment risk and must ensure the plan remains adequately funded.

The contribution amount depends on employee compensation, plan design, and actuarial assumptions. For small business owners, this structure allows for significant tax-deferred contributions, often exceeding the limits of traditional retirement plans. A business owner in their 50s, for instance, may contribute well over $100,000 annually, depending on income levels and plan specifications. These contributions are tax-deductible for the business, reducing taxable income while funding retirement savings.

Cash balance plans must comply with IRS funding requirements under sections 412 and 430 of the Internal Revenue Code. Failure to meet required funding levels can result in penalties. Businesses must work with actuaries and plan administrators to ensure contributions are calculated correctly and deposited on time. Employers have some flexibility in managing contributions, as they can adjust funding levels within certain limits based on business cash flow, provided they meet minimum funding requirements.

Participation and Vesting

Employees must meet specific eligibility requirements before participating in a cash balance plan. Many businesses set an age and service requirement, such as being at least 21 years old and completing one year of service with at least 1,000 hours worked. Employers have some flexibility in defining these rules but must comply with IRS regulations to ensure fair access to benefits.

Once an employee becomes a participant, vesting determines how much of the employer’s contributions they keep if they leave the company. Unlike 401(k) plans, where employee contributions are always vested, cash balance plans only vest employer-funded benefits. The IRS permits two primary vesting schedules: three-year cliff vesting, where employees receive 100% of their benefits after three years, or graded vesting, where ownership increases incrementally, such as 20% per year over five years.

Vesting schedules impact an employee’s retirement savings, especially for those who change jobs frequently. Someone leaving before meeting the vesting requirement may forfeit all or part of their accrued benefit. This structure encourages long-term employment while helping businesses manage costs by reducing payouts to short-term employees.

Distribution Options

When participants retire or leave employment, they must decide how to receive their accumulated benefits. Unlike traditional pensions that typically provide only annuity payments, cash balance plans offer multiple distribution methods.

Lump-Sum Payout

A lump-sum distribution allows participants to withdraw their entire account balance at once. This option provides immediate access to funds, which can be reinvested, used for major expenses, or rolled into another retirement account. However, withdrawing the full amount triggers immediate tax consequences. The IRS treats lump-sum payouts as ordinary income, subject to federal and state income taxes. If the participant is under 59½, an additional 10% early withdrawal penalty may apply unless an exception applies.

For example, if a retiree receives a $500,000 lump sum and falls into the 32% federal tax bracket, they could owe $160,000 in federal taxes alone. To mitigate tax liability, many participants roll the funds into an IRA or another qualified plan, deferring taxes until withdrawals begin. Businesses must ensure proper tax withholding, typically 20% for direct distributions, as required by IRS regulations.

Lifetime Annuity

An annuity option converts the account balance into a series of guaranteed payments for life. The monthly benefit amount depends on factors such as the participant’s age, account balance, and selected annuity type. Common choices include single-life annuities, which provide the highest monthly payments but cease upon the retiree’s death, and joint-and-survivor annuities, which continue payments to a spouse at a reduced rate after the participant’s passing.

Annuities help mitigate longevity risk—the possibility of outliving retirement savings—by ensuring a steady income stream. However, they lack liquidity, meaning participants cannot access additional funds beyond the scheduled payments. The IRS requires that annuity payments meet minimum distribution rules, ensuring retirees begin withdrawals by April 1 of the year following the year they turn 73 (as of 2024).

Rollover Options

Participants who prefer to maintain investment control and defer taxes can roll their cash balance plan funds into another qualified retirement account, such as a traditional IRA or another employer-sponsored plan. A direct rollover avoids immediate taxation, preserving the full account balance for future growth. If a participant instead receives the funds and deposits them into a new account within 60 days, they must replace the mandatory 20% withholding from other sources to avoid tax penalties.

Rolling funds into an IRA provides investment flexibility, allowing retirees to choose asset allocations that match their risk tolerance and retirement goals. Additionally, IRAs offer more withdrawal options than employer-sponsored plans, including Roth conversions, which allow tax-free withdrawals in retirement if certain conditions are met. However, once rolled over, the funds lose the creditor protections of ERISA-covered plans, which may be a consideration for high-net-worth individuals concerned about asset protection.

Regulatory Requirements

Cash balance plans must comply with ERISA and Internal Revenue Code provisions governing defined benefit plans. Nondiscrimination testing ensures benefits do not disproportionately favor highly compensated employees. The IRS uses tests such as the minimum participation rule and the coverage test to verify compliance. Employers must demonstrate that a sufficient percentage of non-highly compensated employees receive meaningful benefits.

These plans are also subject to annual actuarial valuations to confirm they are adequately funded. The Pension Protection Act of 2006 introduced stricter funding rules, requiring employers to maintain specific funding levels based on plan liabilities. Underfunded plans may trigger additional contributions or funding notices to participants. The IRS also mandates that plan documents be updated periodically to reflect legislative changes. Failure to comply can result in excise taxes, plan disqualification, or fiduciary liability under ERISA.

Plan Termination

Businesses may terminate a cash balance plan due to financial constraints, changes in business structure, or a shift in retirement plan strategy. Terminating a defined benefit plan requires regulatory approval and adherence to strict distribution rules. Employers must notify participants and file termination paperwork with the Pension Benefit Guaranty Corporation (PBGC) if the plan is covered by PBGC insurance. The plan must also be fully funded at termination to ensure all accrued benefits are paid out.

Once the termination process begins, participants receive their vested benefits through lump-sum distributions, annuities, or rollovers, depending on plan provisions. If the plan is underfunded, the employer must contribute additional funds before finalizing the termination. The IRS and Department of Labor may audit the termination process to ensure compliance. Businesses considering termination should evaluate alternative retirement plan options, such as transitioning to a profit-sharing or 401(k) plan, to continue offering retirement benefits while reducing long-term liabilities.