Cash balance plans are a powerful retirement savings tool, but they come with specific rules about who can participate and how benefits are distributed. Employers have flexibility in determining eligibility for both 401k and cash balance plans, but they must comply with legal standards to ensure fairness and compliance. However, cash balance plans have additional flexibility regarding who a plan sponsor must include as a participant compared to a 401k plan. Oftentimes, we find this to be a key factor for the plan sponsor and can lead to a great outcome for a business owner when establishing both a 401k and cash balance plan simultaneously.
We need to start with some basics, and then towards the end we will zero in on the participation requirements.
Who Must Participate in a Cash Balance Plan?
Not all employees must be included in a cash balance plan. Employers can set eligibility criteria based on:
- Employment category (e.g., salaried vs. hourly workers, specific locations, or divisions).
- Age and service requirements, within legal limits.
- Age: Employees must be allowed to join a plan by age 21. No maximum age limits are permitted.
- Service: Typically, employees must complete one year of service (1,000 hours in a 12-month period) to participate. Plans with full and immediate vesting can require two years of service instead.
- Union status, allowing plans to cover only collectively or non-collectively bargained employees.
Note, special rules apply to long-term part-time employees in 401(k) and 403(b) plans, but these rules do not affect cash balance plans.
Entry Date
Once employees meet the eligibility requirements, they must be allowed to enter the plan by:
- The first day of the next plan year, or
- Six months after meeting eligibility conditions.
In addition to setting and adhering to eligibility requirements, cash balance plans must meet compliance testing around coverage requirements and a minimum number of participants.
Meeting Coverage Requirements
To ensure fairness, plans ensure benefits are not unfairly skewed toward highly compensated employees (HCEs). Note, HCEs are defined as someone either owning more than 5% of the company or earning over $160,000 in compensation.
Cash balance plans must satisfy one of two tests:
- Ratio Percentage Test: At least 70% of the percentage of HCEs covered by the plan must be non-HCEs.
- Average Benefits Test: The plan must cover a reasonable, nondiscriminatory classification and provide NHCEs with at least 70% of the average benefits provided to HCEs.
Minimum Participation Requirement
Cash balance plans, must provide “meaningful benefits” to at least:
- 40% of employees, or
- 50 employees, whichever is fewer.
- But, in no event, less than 2 employees, unless there is only one non-excludable employee
To qualify as meaningful, the IRS generally accepts benefit accruals of at least 0.5% of pay per year.
How Minimum Participation Rules Differ Between Cash Balance and 401(k) Plans
A key distinction between cash balance plans and 401(k) plans lies in the minimum participation requirement and how eligibility impacts participation. Understanding these differences is critical for plan sponsors, particularly for small businesses looking to maximize retirement benefits while managing costs.
401(k) Plans: Broad Inclusion Requirement
In a 401(k) plan, all employees who meet age and service eligibility requirements must be allowed to participate. For example:
- Employees must generally be eligible to defer salary contributions after one year of service (or even sooner, depending on the plan).
- Recent SECURE Act changes mandate that long-term part-time employees (working at least 500 hours for two consecutive years) must also be given the option to participate.
- While employers can set their own contribution policies (such as who receives matching or profit-sharing contributions), all eligible employees must be allowed to defer their own wages into the plan.
Because of this broad inclusion requirement, 401(k) plans are not necessarily ideal for business owners looking to concentrate benefits among a select group of employees, such as themselves and key personnel.
Cash Balance Plans: Selective Participation via Minimum Participation Rule
In contrast, cash balance plans are subject to a different, more flexible rule as previously discussed; they must benefit at least 40% of employees or 50 employees, whichever is lower (with some additional nuance around companies with small number of employees).
Cash balance plans do not require the employer to include every employee who is eligible to participate. Instead, the employer can limit participation to select employees – typically business owners, executives, and certain staff – while still passing compliance tests.
For example, consider a small business with 10 employees, including:
- 2 owners who are highly compensated
- 1 child of the owner employed in the business
- 7 rank-and-file employees who may not need or want additional retirement benefits.
The company could design a cash balance plan (likely alongside a 401k plan) that covers only four out of the ten employees (40%) – for instance, the two owners, their child, and 1 employee – while excluding the remaining six employees.
This targeted participation allows business owners and key personnel to maximize their tax-deferred retirement savings, while meeting all testing requirements and ensuring employees receive a retirement benefit as well.
We’d love to have a discussion with you about tailoring a tax-advantaged retirement plan to your liking. Our passion is improving retirement outcomes for small business owners and their employees.
Reach out if you’d like to learn more at [email protected].