Cash Balance Plans (Defined Benefit): The “Super-401(k)” for High-Income Earners
Cash Balance Plans (Defined Benefit): The “Super-401(k)” for High-Income Earners
๐ WHO THIS IS FOR (Prerequisites)
- Required Profile: Profitable business owners or partners aged 40-60 who have “maxed out” their 401(k) and still face a massive tax bill.
- Primary Objective: Tax Compression (Reducing current year taxable income by $200k – $500k+).
- Disqualifying Factor: Unstable cash flow (contributions are mandatory) or younger age (under 35s have lower contribution limits).
โ ๏ธ STRATEGY ELIGIBILITY CHECK
Unlike a 401(k) where you determine the contribution (“Defined Contribution”), here you determine the future payout (“Defined Benefit”), and an actuary calculates what you must save today.
- โ๏ธ Income Floor: Generally requires personal income >$400k-$500k to make the setup costs and mandatory funding worthwhile.
- โ๏ธ Commitment: This is not a “one-off.” You must intend to fund the plan for at least 3-5 years (Permanency Requirement).
- โ๏ธ Employee Match: If you have employees, you typically must contribute ~5-7% of their salary to pass “Non-Discrimination Testing.” (Still profitable if Owner’s allocation > 85%).
- โ๏ธ Asset Protection: Assets are ERISA-protected, offering a fortress against creditors and lawsuits (stronger than IRAs in many states).
EXECUTIVE SUMMARY
- The Premise: The standard 401(k) limit ($69k in 2025) is insufficient for high earners. It barely dents the effective tax rate for someone making $1M+.
- The Edge: Cash Balance Plans layer on top of a 401(k). Because contribution limits are age-based (closer to retirement = higher catch-up), a 55-year-old can often contribute $300,000+ annually Tax-Deductible.
- The Result: You shift ~$300k+ from the “37% Tax Bracket” into a tax-deferred shelter. You save ~$100k-$150k in cash taxes this year.
- The Exit: Upon retirement or plan termination (after 5+ years), the balance can be rolled over into an IRA, continuing the tax deferral.
For the successful business owner, the Cash Balance Plan is the “nuclear option” for tax reduction. It turns your tax liability into your own retirement asset. Source: Dept of Labor (ERISA)
- Persona: 55-Year-Old Business Owner (Sole Owner or Partner).
- Income: $1,000,000 (Net Schedule C or K-1).
- Tax Rate: 45% (Fed + State).
- Comparison: 401(k) Only vs. “Combo Plan” (401k + Cash Balance).
Performance Simulation (The Tax Arbitrage)
| Metric | Standard 401(k) Only | Combo Plan (CB + 401k) | Delta (Alpha) |
|---|---|---|---|
| Gross Income | $1,000,000 | $1,000,000 | – |
| Total Contribution (Deduction) | ($76,500)* | ($376,500)** | +$300k Saved |
| Taxable Income | $923,500 | $623,500 | Lower Bracket |
| Estimated Tax Bill (45%) | ($415,575) | ($280,575) | Save ~$135,000 |
| Wealth Accumulated (Year 1) | $76,500 | $376,500 | +492% Asset Growth |
*Includes Catch-up. **Assumes ~$300k Actuarial Max contribution based on age 55. The tax savings effectively fund 45% of the contribution.
Advanced Mechanics: The “Crediting Rate”
*Managing the investment risk.
| Component | Mechanism | Strategy |
|---|---|---|
| ICR (Interest Crediting Rate) | The plan guarantees a return (e.g., 4% or “30-Year Treasury”). | Do not aim for alpha here. If the portfolio earns 10% but guarantees 4%, the plan becomes “Overfunded,” and you cannot contribute more (losing the deduction). |
| Investment Choice | Pooled assets managed by Trustee. | Target Conservative Returns. Aim to exactly match the ICR (e.g., 4-5%). Use Bonds, Private Credit, or Structured Notes. |
| Overfunding Trap | Assets grow too fast. | If assets exceed the actuarial liability, you must stop contributions. This defeats the purpose of the tax deduction. |
Liquidity Event Planning:
- The Scenario: You sell your business for $10M in Year 5.
- The Move: You terminate the Cash Balance Plan (valid business reason: company sale).
- The Result: The accumulated balance (e.g., $1.5M) is rolled over into a Personal IRA. It remains tax-deferred. You do not pay taxes until you withdraw from the IRA years later.
โ BOUNDARY CLAUSE: Structural Limitations
- Mandatory Funding: In bad years, you still must fund the plan. Failure to fund results in excise taxes and plan disqualification. (Amendments to freeze the plan are possible but complex).
- Actuarial Fees: Unlike a cheap 401(k), these plans require annual certification by an actuary. Costs range from $2k to $5k annually.
๐ค DECISION BRANCH (Logic Tree)
IF Age < 35:
โข Input: High income, young partner.
โข Output: Stick to 401(k) + Profit Sharing. The actuarial limits for young people are too low to justify the setup fees of a DB plan.
IF Age > 45 & Income > $600k:
โข Input: Peak earning years.
โข Output: Mandatory Cash Balance Plan. You are overpaying taxes if you rely only on a defined contribution plan.
Tax deferral is the most reliable form of Alpha. A Cash Balance plan allows you to compounding pre-tax dollars, creating a “snowball” effect that taxable accounts cannot match.