Same family, same limits
The Internal Revenue Code treats a cash balance plan as a defined benefit plan. The same rules apply to both: the benefit at retirement cannot exceed $290,000 a year for life, or 100% of your average pay for your highest three consecutive years if that is lower (IRC 415(b)). Both have a minimum required contribution every year, an annual valuation by an enrolled actuary, and a maximum deductible contribution.
Because the ceiling is the same, the most a one-person business can contribute is broadly the same under either design. What changes is how the promise is written, how the lump sum is worked out, and who carries investment risk in practice.
How the benefit is described
| Traditional defined benefit | Cash balance | |
|---|---|---|
| The promise | A monthly income at retirement, set by a formula such as a percentage of pay for each year of service | An account that receives a pay credit and an interest credit each year |
| What you see on a statement | A projected monthly benefit at normal retirement age | A dollar balance, like a 401(k) |
| Lump sum at retirement | The present value of the monthly benefit, using IRS interest rates and mortality tables at the time of payment | The account balance |
| Vesting | Longer schedules are allowed | Three-year cliff at most |
| Investment gains and losses | Fall on the business: good returns lower future contributions, poor returns raise them | Depends on the crediting method; with actual-return crediting, the account moves with the investments |
Lump sums
Many owners of one-person plans expect to take the money as a single payment and roll it into an IRA. The two designs get there differently.
In a traditional plan the benefit is an annuity, so a lump sum has to be calculated from it. The law sets a floor on that calculation using interest rates and a mortality table that the IRS publishes, and those rates change every month. When rates fall, the same monthly benefit is worth a bigger lump sum, and the plan has to hold enough to pay it.
In a cash balance plan the law lets the lump sum simply equal the account balance (IRC 411(a)(13)). There is no conversion at payout, which makes the number easier to follow from year to year.
Either way, the maximum lump sum is still capped by the 415(b) limit converted at IRS-set rates, so neither design lets you take out more than the law allows.
Interest crediting
A cash balance plan has to say how the account grows. Treasury regulations limit the rate to a market rate of return and list the options:
- a fixed rate of up to 6% a year
- a rate tied to Treasury bond yields or to the IRS segment rates, optionally with a floor
- the actual return on the plan's investments, gains and losses alike, allowed only while the investments are diversified
Whatever method is chosen, the payout cannot be less than the total of the pay credits made over the years. This floor is called preservation of capital. If losses leave the account below it when the money is paid out, the business makes up the difference.
A traditional plan has no interest credit at all. The actuary assumes a return, and if the investments beat or miss it, the next years' contributions absorb the difference. That is why traditional plans can drift into overfunding, which is costly to unwind: surplus assets that cannot be paid as benefits face an excise tax of 20% or 50% on reversion to the business, on top of income tax.
Why the cash balance design suits a one-person business
Both designs can reach the same ceiling, so the choice usually comes down to practical points:
- It is easier to understand. A balance you can see each year is simpler to plan around than a projected annuity.
- The lump sum is the balance. No conversion at IRS rates at the moment you retire.
- Actual-return crediting ties the account to the investments. When the account is credited with what the plan actually earns, the gap between what you are owed and what the plan holds stays small, which reduces the risk of large swings in contributions or a surplus at the end.
- It works well with a Solo 401(k). The account looks and moves like a 401(k) balance, and the two can be planned together. See using a cash balance plan with a Solo 401(k).
A traditional formula can still make sense for someone who wants a guaranteed-style monthly pension or who has an existing traditional plan. Many providers that serve one-person businesses offer both designs, so it is worth asking to see each before you choose.
What stays the same
- The business must contribute at least the minimum each year, and the plan is meant to be permanent.
- An actuary values the plan every year, and Form 5500-EZ is due once plan assets pass $250,000.
- Contributions are deductible by the business within the maximum; they are tax-deferred, not tax-free.
- A plan covering only the owner and spouse sits outside Title I of ERISA and outside the government's pension insurance program, whichever design it uses.
For the basics, see what is a cash balance plan. For figures by age, see how much you can contribute.