Magazine article The CPA Journal

Cash-Balance Pension Plans

Magazine article The CPA Journal

Cash-Balance Pension Plans

Article excerpt

An Opportunity to Maximize Retirement Planning Strategies and Reduce Taxes

The 2008 financial crisis and resulting recession had a devastating effect on the financial health and retirement plans of many small business owners and small to medium-sized professional groups. Over the past few years, business owners have worked hard to rebuild. Now, with recovery in sight, the American Taxpayer Relief Act of 2012 (ATRA) creates new challenges for highincome taxpayers.

Higher income tax brackets at the federal level, reduced itemized phaseouts on deductions, and surcharges on net investment income and earned income will subject high-income individuals and families to even higher combined marginal tax rates. For business owners and professional groups, cash-balance pension plans might present an opportunity to maximize or catch up on their retirement-planning strategies, reduce taxable income, and take advantage of asset and creditor protection.

What is a Cash-Balance Plan?

Considered to be hybrids, cash-balance pension plans are a type of retirement plan that offers the unique characteristics of traditional defined-benefit plans, with annual contributions and promised retirement benefits, and the individual account features and portability of defined-contribution plans. Two major differences between a traditional defined-benefit plan and a cashbalance plan exist.

First, under a traditional defined-benefit plan, an employee receives upon retirement a specific benefit that is defined as an annuity or a series of monthly payments for life; under a cash-balance plan, on the other hand, the employee benefit is tie value of the employee's account. This can be turned into an annuity, taken as a lump-sum distribution, or rolled over into an individual retirement account (IRA) or other type of qualified account.

Second, under a traditional defined-benefit plan, the amount that must be funded annually into the plan is based upon the retirement benefit promised to each participant, irrespective of investment returns for the plan. If the investment returns for the plan do not meet the actuarial rate of return needed to meet the retirement benefit, it creates an unfunded liability for the employer. In a cash-balance plan, the employer makes contributions based upon a hypothetical pay credit (either a percentage of annual compensation or a fixed dollar amount) and a hypothetical interest credit rate (ICR). The ICR can be set annually to match the market's return (or the plan's actual investment return), eliminating the potential for an unfunded liability. Although cash-balance pension plans were created in 1985, they have gained momentum since the 1RS provided clarity regarding the ICR in late 2010.

How Cash-Balance Plans Work

First, a hypothetical account is set up for each employee in the plan. On an annual basis, the employer makes a contribution into each employee's account. This amount can differ by employee, and not all employees need to participate in the plan; however, the plan must comply with cer- tain 1RS rules and regulations. The hypothetical account balance for each employee is adjusted annually, based upon the ICR used. The 1RS now allows the ICR to be equal to the plan's actual rate of return, as long as the plan's investments are adequately diversified; therefore, the value of the plan's assets is always equal to its account balances. Employee balances vest after three years.

Example. Consider a closely held organization with four owners and 16 employees, shown in the Exhibit. …

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