Part 2: How a Cash Balance Plan Works
In Part 1, we introduced the cash balance plan as a powerful retirement and tax-saving tool for high-income earners and business owners. Now let’s dig into how these plans actually work — the mechanics behind the scenes that make them so valuable.
The Basic Structure
A cash balance plan is a defined benefit retirement plan. That means the plan promises a specific benefit at retirement — but it presents that benefit in terms of a hypothetical account balance that grows each year with:
1. Pay Credits – Annual contributions made on your behalf (typically a percentage of compensation or a flat dollar amount), and
2. Interest Credits – A fixed or variable rate of return that the account earns annually.
Example:
Dr. Smith, age 55, has a plan that provides a $200,000 annual pay credit and a 5% interest credit. Each year, her “account” grows by $200,000 plus 5% of the balance — even though the actual funds are pooled and invested behind the scenes.
Who Contributes to the Plan?
These are employer-funded plans, so the business is responsible for making all contributions. That includes any benefits provided to employees, though the plan can be designed to skew most of the benefit toward the owner(s), as long as minimum employee contribution requirements are met.
If you already sponsor a 401(k) + profit-sharing plan, a cash balance plan can be layered on top — this combo is common and often referred to as a “combo plan.”
How Much Can You Contribute?
Unlike defined contribution plans (like a 401(k)), cash balance plan limits aren’t based on annual IRS caps — they’re based on actuarial formulas that allow large contributions as you age. For example, someone in their mid-50s might contribute $200,000–$300,000 per year — all tax-deductible to the business.
The older you are, the more you can contribute. Why? Because you have fewer years left to reach the IRS-defined maximum lifetime benefit.
What’s an “Interest Credit,” and Why Does It Matter?
Each year, your hypothetical account balance is credited with an “interest credit,” usually one of the following:
• Fixed Rate (e.g., 4% annually)
• Variable Rate tied to a benchmark (e.g., 30-year Treasury)
This rate matters because the plan’s investments need to generate enough return to cover those promised credits. If the portfolio underperforms, the business may have to contribute more to meet funding targets. If it outperforms, you may have a funding surplus.
This is why many plans use conservative, steady investment strategies — think bond-heavy portfolios — to reduce volatility and contribution surprises.
How It Works with Employees
If you have employees, your plan must pass certain nondiscrimination tests. But that doesn’t mean it has to be expensive. Many plans are designed to give owners the majority of the benefits while keeping employee costs reasonable — often around 5%–7.5% of pay for eligible staff.
A good actuary and advisor team will run custom designs to strike the right balance.
A Real-World Example
Let’s say a 52-year-old solo business owner has steady income and is looking to max out retirement contributions:
• 401(k) deferral + profit sharing: $76,500 (2025 limit)
• Cash balance plan contribution: ~$185,000
• Total retirement savings: Over $260,000 — all tax-deferred
That’s a huge win for both long-term wealth building and short-term tax reduction.
Coming Up Next
In Part 3, we’ll cover what it takes to set up and maintain a cash balance plan — including what the process looks like, who you need on your team, and how to avoid common pitfalls.
Have questions about how this could work for your business? Let’s Talk
Ready for part 3? Click Here
