So, you established a 401(k) plan for your company and have been contributing consistently for years. The plan has likely afforded your company significant tax savings and has allowed you to attract and retain quality employees. While a 401(k) plan is a great savings vehicle, did you know there is a type of qualified retirement plan that will allow you to contribute significantly more than the maximum allowed in a stand-alone 401(k) profit sharing plan?
We are all familiar with defined contribution plans (e.g., 401(k) and profit sharing plans). You are probably also familiar with traditional defined benefit plans, or pension plans, historically sponsored by large companies to provide monthly retirement benefits to their retirees. For business owners that are looking for large tax deductions, accelerated retirement savings, and additional flexibility, another type of defined benefit plan, a cash balance plan, may be the perfect solution.
How does a cash balance plan work?
As mentioned above, a cash balance plan is a type of defined benefit plan. In general, defined benefit plans provide a specific benefit at retirement to participants. While traditional defined benefit plans define an employee’s benefit as a series of monthly payments for life to begin at retirement, cash balance plans state the benefit as a hypothetical account balance. Each year, this hypothetical account is credited with following:
- A pay credit, such as a percentage of annual pay or a fixed dollar amount that is specified in the plan document.
- A guaranteed interest credit (either a fixed rate or a variable rate that is linked to an index such as the one-year treasury bill rate).
The accounts in a cash balance plan are referred to as hypothetical because, unlike defined contribution plans, the plan assets are held in a pooled account managed by the employer, or an investment manager appointed by the employer. The hypothetical account balances are an attractive feature of cash balance plans because these accounts tend to be easier for participants to understand, as the annual benefit statements reflect the value of their account, similar to 401(k) profit sharing plan account statements.
Unlike a 401(k) profit sharing plan, a defined benefit plan guarantees the benefit each participant will ultimately receive. The plan’s actuary calculates the benefits earned each year based on the terms of the plan document, which in turn determines the required employer contribution due to the plan.
When a participant becomes entitled to receive their benefit from a cash balance plan, the benefits are defined in terms of an account balance and can be paid as an annuity based on that account balance. In many cash balance plans, the participant also has the option (with consent from his or her spouse) to take a lump sum benefit that can be rolled over into an IRA or to another employer’s plan.
What if I already sponsor a 401(k) profit sharing plan?
In most cases, cash balance plans work best when paired with a 401(k) profit sharing plan. To optimize the combined plan design, it’s possible that certain provisions in your current plan may need to be amended. This is especially true if the cash balance plan covers non-owner employees. Due to the large benefits that are typically earned by the owner and/or other key employees, the combined plans must pass certain nondiscrimination tests. These tests are more easily passed when employer contributions are provided to the staff under the 401(k) profit sharing plan as safe harbor nonelective and profit sharing contributions. While company contributions in a stand-alone 401(k) profit sharing plan may be discretionary, when combined with a cash balance plan, these contributions become required as well, since without them, the combined plans will likely not pass all required nondiscrimination tests.
Are cash balance plans a good fit for everyone?
Unfortunately, the answer to this question is no. The first question to ask yourself is if you wish to make contributions in excess of the defined contribution limit ($58,000 or $64,500 for participants over age 50 for 2021). If the answer to this is yes, then the demographics of the employer must be considered. Since the maximum contributions are age dependent, cash balance plans typically work best when targeted employees are older than the average age of other staff members. And maybe most importantly – do you anticipate consistent profits that will allow you to fund all required contributions for the foreseeable future?
Cash balance plans sound too good to be true. What’s the catch?
If you’ve decided setting up a cash balance plan sounds like the perfect way to meet your retirement goals and attract and retain quality employees, you may be right! However, as good as this sounds, there are many important factors to consider before jumping in. Here are a few key considerations:
- Cash balance plans can be designed with some flexibility, such as setting up pay credits using a percentage of annual pay, but the annual contribution calculated by the actuary is required. When paired with a 401(k) profit sharing plan to pass nondiscrimination testing, the employer contributions to that plan become required as well.
- Because the annual interest credit is guaranteed, the employer bears the investment risk for the plan. If the rate of return on investments is less than expected, the required contribution may increase to make up for the shortfall.
- Qualified retirement plans must be established with the intent of being permanent. Many service providers recommend maintaining the plan for at least three to five years to satisfy this requirement.
- Cash balance plans are often more complex, and as a result, more costly to establish and maintain than defined contribution plans.
For employers that desire increased retirement savings and tax deductions, cash balance plans may be the perfect addition to their employee benefit program. However, as previously mentioned, they are not a good fit for everyone. It’s important to work with an experienced service provider to determine if a cash balance plan is right for you.
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This newsletter is intended to provide general information on matters of interest in the area of qualified retirement plans and is distributed with the understanding that the publisher and distributor are not rendering legal, tax or other professional advice. Readers should not act or rely on any information in this newsletter without first seeking the advice of an independent tax advisor such as an attorney or CPA.
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Spring will arrive soon, promising new growth and a fresh beginning. It could also be the perfect time to do some spring cleaning for your plan. Let’s look at some areas that you might consider reviewing to ensure your retirement plan is operating efficiently.
Document your processes and procedures to make certain that plan tasks can be handled in case of any absences during an enrollment or pay period. Having a backup in place can prevent errors and delays that could lead to penalties.
Make sure to have a process in place to notify all new enrollments of their eligibility, regardless of whether the plan has automatic enrollment. Depending on the timing for plan entry, including the plan enrollment paperwork with the new hire paperwork could make entry easier for you. Please reach out with any questions regarding when an employee enters the plan.
Deposits of employee deferrals and loan repayments must be submitted to the plan as soon as possible to avoid penalties and corrections. For plans with less than 100 participants, a safe harbor rule allows deposits to be made within seven business days. For larger plans, the expectation is that the money will be deposited more quickly. Depositing these funds on the pay date will avoid the possibility of being late.
Monitoring deferral contribution limits during the calendar year will avoid refunds after year end. Make sure that your payroll is set up to stop deferrals once the limit is reached, including any catch-up contributions for those who have reached age 50.
To keep the plan in compliance, employer contributions must be deposited timely. Due dates are impacted by the type of contributions, required status and tax deductibility. If you have questions on when to deposit your employer contribution or even whether to make an employer contribution, please contact us.
Most plans must be covered by a fidelity bond. The minimum coverage is 10% of plan assets (rounded up to the next $1,000) and the maximum coverage is $500,000. Additional requirements apply to plans with employer securities or non-publicly traded assets. If your fidelity bond is insufficient, now is the time to raise the coverage. Inflation clauses that increase the bond amount as the plan assets increase can ensure that your bond coverage is always adequate. Contact us or your insurance provider if you don’t have a fidelity bond.
Another area to review is communication with participants. Helping your employees understand and trust the plan can increase their contributions. Be sure that your procedures include distributing any plan-related communications—including required participant notices.
Distributions also involve communication, including some of the aforementioned notices. Discussing distribution options with terminated participants, possibly as part of an exit interview, can help to reduce risk of lost participants. We’ll provide instruction on distributions for force-out distributions for small balances, testing corrections and required minimum distributions.
Your plan document is the legal source on how the plan should be administered; operating within its parameters is critical. It’s always worth taking time to review the plan document to ensure that you fully understand and are following its provisions. We’ll cover more details about the plan document later in this newsletter. We’re here to support you in keeping your plan in compliance. Please feel free to reach out with any questions.
Addressing the Challenge of Uncashed Distribution Checks
Uncashed distribution checks present a persistent and often overlooked challenge for retirement plan sponsors. Despite the best efforts of plan administrators, some participants fail to cash their distribution checks, leading to administrative burdens, fiduciary concerns and potential compliance issues. A recent publication by Retirement Management Services (RMS) sheds light on this issue and offers practical guidance for employers seeking to manage and mitigate the risks associated with uncashed checks.
Uncashed checks can arise for various reasons. Participants may have moved without updating their contact information, may not recognize the check as legitimate or may simply forget to deposit it. Regardless of the cause, the responsibility for addressing these uncashed funds ultimately falls on the plan sponsor. This creates a fiduciary obligation to act in the best interest of the participant while ensuring compliance with IRS and Department of Labor (DOL) regulations.
Sponsors are encouraged to maintain up-to-date contact information for all plan participants and to follow up promptly when checks remain uncashed. This may involve sending reminder letters, making phone calls or using certified mail to confirm receipt. In some cases, plan sponsors may also consider using electronic payment methods to reduce the likelihood of checks going uncashed in the first place.
The IRS and DOL have issued guidance on how to handle these situations, including the use of forfeiture accounts and escheatment to state unclaimed property programs. However, these options come with their own set of rules and potential pitfalls. For example, using a forfeiture account may require the plan document to explicitly allow for such treatment. Escheatment laws, which allow the government to assume control of unclaimed property, vary by state. As such, plan sponsors must carefully evaluate their options and consult with legal or compliance experts as needed.
Another important consideration is the documentation of all the efforts made to contact participants and resolve uncashed checks. Maintaining a clear audit trail can help demonstrate fiduciary prudence and protect the plan sponsor in the event of an audit or legal challenge. It is extremely important to have a written policy in place that outlines the steps to be taken when a check remains uncashed beyond a certain period.
By taking a proactive, well-documented and compliant approach, employers can fulfill their fiduciary duties, reduce administrative burdens and ensure that participants receive the benefits they are entitled to.
Source: Retirement Management Services – “Uncashed Distribution Checks” https://www.consultrms.com/Resources/59/Plan-Sponsor-Tips-and-Help/212/Uncashed-Distribution-Checks
Divorce and the Retirement Plan
When a participant in a qualified retirement plan undergoes a divorce, the participant’s account balance may be an asset that is split with the former spouse. As the plan exists for the exclusive benefit of its participants, a court order is required to transfer the participant’s benefits to the ex-spouse. Once approved by the plan administrator, this court order is called a Qualified Domestic Relations Order (QDRO).
The QDRO is a judgment, decree or order that must be issued by a state authority (usually a court). It can be part of the divorce settlement or it may be a separate document. Because of the serious nature of separating the participant’s account balance, the QDRO is more than just an agreement made by both parties — it must also be signed by a judge.
A QDRO will describe how to divide the participant’s account balance between the participant and the ex-spouse, referred to as the alternate payee. In some cases, a set dollar amount will be allocated; in others, a percentage of the account may be designated. In the latter case, the amount assigned to the alternate payee represents the given percentage of the participant’s total vested account balance as of a specified valuation date. This percentage will apply to all sources — such as deferrals, matching or profit sharing — unless specified by the QDRO. Any interest and investment gains/losses that accrue between this valuation date and the date the funds are separated into an account for the alternate payee are often factored into this final calculation. If the participant has outstanding loans, the QDRO will usually indicate how the loans are handled.
Contributions such as deferrals and employer matching made after the valuation date are credited to the participant’s account. Earnings and losses are applied to the account balances. Once the division is complete, the alternate payee’s portion (either dollars or shares) is transferred to an account in the alternate payee’s name.
If the plan allows, the alternate payee may be paid out in a cash or rollover distribution. Not all plan documents allow the alternate payee to receive a distribution before reaching normal retirement age, so it’s important to follow the terms of the plan. In addition, the QDRO cannot violate the provisions of the plan document by requiring a plan to provide an alternate payee or participant with any type or form of benefit not otherwise provided under the plan.
Although the most common situation for a QDRO is a divorce, it can be issued in other situations, such as to a dependent in the case of child support. If the alternate payee is a minor child or legally incompetent, the order can also require payment to the individual with legal responsibility for the alternate payee. If a participant or their attorney provides you with a copy of a divorce decree that references the plan or a QDRO, please contact us immediately, and we will work with you to ensure it meets the requirements of the plan.
Important note for defined benefit plans: For 2025 plan years, PBGC premiums are due one month earlier than usual, specifically on the 15th day of the ninth month after the beginning of the plan year. For calendar year plans, this means the premium is due on September 15, 2025, instead of the usual October 15. This accelerated deadline is due to a provision in the Bipartisan Budget Act of 2015.
Upcoming Compliance Deadlines for Calendar-Year Plans
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