By Paul Sundin, CPA, President of Emparion; A 2022 Platinum WCI Medical School Scholarship Sponsor

By now, you are probably aware of all the advantages of cash balance plans. They are home runs for physicians and other business owners in the right scenario.

A cash balance plan is probably your best bet if your goal is a tax-deductible contribution over $100,000. The contributions far exceed the contributions for other types of retirement plans.

All too often, though, business owners focus on all the benefits, and the pitfalls don't get adequately discussed. While many downsides can be mitigated, you certainly want to be educated. This post will cover the top 10 mistakes people make when setting up these cash balance plans. Hopefully, you won't make any of these mistakes when you set up yours.

But first, I will provide some background.


What Is a Cash Balance Plan?

When business owners first consider retirement plans, they often choose a 401(k) or a SEP IRA. These plans are great options but come with low contribution limits for high-income business owners.

There are two broad categories of retirement plans: defined benefit plans and defined contribution plans. A cash balance plan is a type of defined benefit plan, and a 401(k) is a type of defined contribution plan. Defined benefit plans aim to generate a benefit upon retirement. Defined contribution plans specify a maximum contribution limit upfront.

Cash balance plans can provide a retirement benefit of up to $3 million. Because of how the contributions are calculated, the plans do not have the annual limits associated with a 401(k) or SEP. As such, they allow much larger contributions that increase with age and compensation.

Like 401(k) plans, cash balance plans work great for owner-only businesses and small companies. But they are a little more complex to administer. The plans need to be established by a third-party administrator and reviewed at least annually by an actuary.


How Do Cash Balance Plans Work?

Cash balance plan participants receive an annual contribution. Each employee has a hypothetical account balance similar to a 401(k) or a profit-sharing plan. The actuary tracks these accounts.

Employee accounts grow in two specific ways:

  • A pay credit: This can be based on a percentage of pay or a flat dollar amount specified in the plan document; and
  • An interest credit: This is a fixed or variable rate independent of the plan's investment performance.

Even though you can make much larger contributions to a cash balance plan than a 401(k), annual contributions come with a target, minimum, and maximum. You have some flexibility in your yearly contributions.

Now that you understand the basics, let's explore my top 10 mistakes and discuss how best to structure a plan. Let's dive in.


Top 10 Mistakes for Cash Balance Plans


#1 Not Considering Prior Service Allocation

When you initially set up a plan, you have some advantages. Depending on how long you've been in business and your compensation levels, you can frontload a plan and make a substantial contribution in year 1.

One of the ways to make this larger first-year contribution is to “pull in” compensation from prior years. Essentially, the plan states that all eligible employees will get an initial plan credit for services previously provided. This allows you to make a year 1 contribution that covers several years.

Another added benefit is that you can amortize this prior service portion over seven years. This will give you funding flexibility in the first several years of the plan's life. That way, you can take advantage of the time value of money upfront.


#2 Max Funding Other Retirement Plans

Thanks to recent IRS changes, you can now open up and fund a cash balance plan before filing the tax return for the previous year. Many people establish and fund these plans in the summer or fall months for the preceding year. They aim to contribute just before the tax return filing deadline.

But one problem often comes up. With all the benefits of cash balance plans, they can be challenging when combined with different retirement plans. In fact, the combination rules will limit or restrict funding for other plans.

Cash balance plans will typically combine well with a 401(k) plan. However, profit-sharing contributions are reduced to 6% of deemed compensation. Many people will fund the maximum 25% profit sharing for the 401(k) plan and think they can layer a cash balance plan on top. But if you've fully funded a 401(k) plan, your cash balance plan funding will be substantially limited.

In addition, many clients will come to us when they have already funded a SEP plan. SEPs are prevalent retirement structures because the IRS has always allowed them to be opened up and funded just before the tax deadline. But the problem is that they don't combine well with a cash balance plan.

SEP plans fall into two categories: (1) model SEPs; and (2) non-model SEPs. Model SEPs cannot be combined with cash balance plans. But non-model SEPs can be combined. However, they are still subject to the 6% contribution limitation.

Clients often come to us after they have max-funded other plans and don't realize there are rules when combining them. I always tell clients that if they are considering setting up a cash balance plan, they should not fund any other retirement structures until they decide on their retirement plans.


#3 Not Understanding Plan Permanency

Most clients are looking for a plan that they can fund until retirement. But some people are just looking for a significant contribution for a year and then want to terminate the plan.

The IRS clearly states that these plans are permanent. But that doesn't mean you have to have them open forever or for the remaining life of the company. The IRS says you should have the plans open for at least several years.

What does “several years” mean? It's tough to say because the IRS did not specify a threshold. But needless to say, these plans should have permanent intent. It should be something that you're looking to have indefinitely.

But just because you have long-term intent does not mean you must have the plan open forever. Businesses can change and evolve. You can certainly terminate a plan if circumstances change and your financial situation deteriorates. In fact, many business owners had to terminate their plans due to COVID. I think the IRS understands this. But still, the goal is to have long-term intent.

cash balance plans


#4 Don't Consider Higher Fee Structure

You're probably aware that cash balance plans carry relatively high fee structures. This is because of the required actuary certification.

But these plans have other factors that make them more complex to administer. Since they are defined benefit plans, you are not dealing with standard annual contribution limits. You receive a funding range that depends mainly on your age, compensation, and investment returns. There just are more tasks for the administrator to do.

Depending on plan structure and number of employees, setup fees typically range from $1,000-$2,000, and annual administration will usually run from $2,000-$3,000. So, if you're looking only to contribute $20,000-$30,000 into retirement, stick with a 401(k) or another type of defined contribution plan. If you're looking for contributions of $100,000 a year or more, you will need a cash balance plan.


#5 Putting All Funds in Stocks or Volatile Assets

You're probably aware of how volatile the stock market can be. Cash balance plans don't like volatility. One of the biggest mistakes you can make is not understanding investment options and how they impact the plan contributions.

First of all, your plan most likely has a fixed interest crediting rate (probably around 5%). This means the plan assets have an assumed return of 5%, and the actuary will model contribution levels using this rate. As such, the plan's goal is to mirror this rate generally.

Most physicians and high-income business owners seek consistent annual contributions to lower taxable income. That's why they want to ensure that they invest plan assets conservatively.

Significant investment gains and losses lead to funding volatility. This leads to large swings in annual required contributions. I recommend using a conservative investment approach with a mix of stocks, bonds, and other non-volatile investments. An investment allocated 100% to stocks is not recommended.

If you desire more stock market exposure, please consider increasing stock allocations in IRAs, 401(k)s, and other defined contribution structures. This way, you can have an aggressive portfolio in your IRAs and defined contribution plans, with a conservative mix in your cash balance plan. Overall, you can adjust your retirement plans to maximize your portfolio allocation.

Just because you can manage your investments does not mean you should. If you are uncomfortable managing these investments, you should consider using a financial advisor that is familiar with these plans.


#6 Don't Forget About Mandatory Contributions

I'm guessing you heard these plans have mandatory contributions. This isn't 100% accurate, though, because we often see people frontloading plans with high early plan year contributions. People often take advantage of the time value of money and its relation to investments and tax deductions.

You may find that if you aggressively fund the early plan years, you might not have a mandatory funding requirement for a given year. In fact, you're given a target contribution each year, but you also have minimum and maximum funding levels.

Most high-income clients don't have a problem with mandatory contributions. But sometimes, you'll see situations where business is down. A company loses a contract or other conditions that can lead to cash-flow problems. In fact, we have seen people not wanting to fund a plan because they were going to buy a new Ferrari or build a new house. We even had one client whose medical practice burned down.

I understand that people can have funding issues. But remember that these plans are permanent, and you must ensure adequate funding to cover annual minimum contribution requirements.

If you can't make a minimum contribution, there will be an excise tax penalty. But you do have several options before an excise tax is imposed. In addition, you have the flexibility of when you can fund the plan. Make sure you communicate any funding concerns ASAP to your administrator.


#7 Not Customizing the Plan

Many clients fail to realize that these plans are highly customizable. The goal is to ensure you get the largest contribution and tax benefit in the year you want. If you have employees, the aim in most situations is to limit employee allocations. An owner contribution of at least 85% is generally the goal.

But there are many ways to customize these plans to work for you. Some of the customizations include:

  1. Using a “tiered” structure with additional pay credits for different compensation levels.
  2. Frontloading a plan or keeping allocations low for a couple of years and then opening up funding for a maximum contribution.
  3. Maximizing owner allocations while limiting employee allocations by only providing employees a “meaningful benefit.”
  4. Giving employees a percentage of pay or even a flat dollar amount.

When setting up a plan, ensure that you discuss plan customizations and tailor the plan to your specific needs. Get the right structure upfront to avoid problems down the road.


#8 Poor Communication

Communication is critical in business relationships. Certainly, some plan administrators don't do their best when communicating with clients. Many specialize in 401(k) plans and have limited knowledge of defined benefit plans, so they have to outsource to an actuary.

But poor communication can work both ways. You often see that clients do poorly communicating with administrators. Sometimes this is because they're not very familiar with the plans and how they work.

Let's face it: I estimate that over 90% of financial advisors and tax professionals don't understand these plans. It is imperative to ensure that all parties understand how the plan is structured and that they can freely communicate about the plan design.


#9 Overfunding Plan

You may have heard that overfunding cash balance plans can be a problem. It can. Many people get very concerned about overfunding. But there are ways to mitigate it.

The IRS allows a maximum amount in these plans of approximately $3 million per individual (and per control group). This gets indexed each year upward, so the maximum continues to grow.

Accumulating $3 million in a plan might seem like a challenge. But, considering the investment mistake noted above, if the plan is invested heavily in stocks or any speculative investments, you might hit that number sooner than you thought.

So, what happens when a plan gets overfunded? When an overfunded plan is terminated, the IRS assesses a 50% excise tax penalty on the overfunded balance. If that's not enough, the entire overfunded balance is subject to reversion. This means the overfunded amount comes back as income to you or the business entity. You could see yourself spending 40%-50% in tax (depending on the state you live in). Essentially, you lose the entire overfunded balance.

This sounds somewhat harsh. I see clients concerned about this in the early years when a plan is set up. But overfunding is typically not an issue. You'll get a little funding flexibility early on. However, you can have problems if you continue to fund aggressively and get high asset return rates.

Thankfully, there are some strategies that can help avert or mitigate overfunding problems. It comes back to communicating with your administrator if you feel that your balance is getting a little high. You will generally know because your annual contribution levels will tend to decrease over this period.

At the end of the day, very few people will have to worry about reversion and paying an excise tax. Careful planning can be done to minimize the impact of any overfunding.


#10 Not Doing a Complete Tax Analysis

Did I mention that most CPAs don't know how these tax plans work? When considering a plan, you should work with your CPA to correctly calculate the plan's tax impact. You must first take your marginal tax rate (the tax that each next dollar is taxed). Then take the planned contribution and reduce it, possibly going down into a lower tax bracket.

In addition, you want to make sure you consider state taxes. State tax rates vary across the country. In addition, a few states don't give you a tax deduction for your contribution. They also don't tax pensions when you take the money out.

Reflecting the tax deduction on an S-Corp or C-Corp tax return is generally not that challenging. But it's certainly more complex for a sole proprietor or partnership.

I often see CPAs taking the deduction directly on Schedule C for a solo plan. However, the deduction should actually be taken as an adjustment to income, and Schedule C should only reflect employee contributions.

Make sure you and your tax professional carefully review the plan so you're educated on your actual tax savings. The amount should be properly reflected on your tax return to avoid any IRS issues.


If you think a cash balance plan is right for you, ensure that you consider not only the pros but the cons as well. Proper upfront planning with all parties is imperative.

What is our favorite plan structure? We like to use prior service, flexible funding ranges, and conservative index investments. But most importantly, our favorite structure mitigates all the mistakes listed above.

Cash balance plans are powerful retirement tools and should be considered by most self-employed physicians and other high-income business owners. Hopefully, you won't make any of these mistakes when setting up your plan.

[Editor's Note: Many thanks to Paul Sundin and Emparion, one of our Platinum Level (contributing $8,000+) Sponsors for the WCI Medical School Scholarship, and their relationship with WCI and helping physicians and other high earners with strategic retirement services. This is the first of our five scholarship-sponsored posts for 2022. Emparion's strategies include cash balance plans, defined benefit plans, 401(k)s, and other retirement vehicles, and Paul's goal for the past 25 years has been to educate clients on retirement strategies, tax strategies, and personal finance. Thank you for supporting those who support this site and especially the scholarship. All proceeds go to the scholarship winners.]