The Pension Protection Act of 2006: Legalizing the Cash Balance Plan

​This letter is part of a series on cash balance retirement plans, one of the best strategies to help high-earning Americans reduce taxes and accelerate their retirement savings. Since the loosening of IRS restrictions in recent years, cash balance plans have become extremely popular and only continue to grow, commanding over $1 trillion in assets. Adding a cash balance plan on top of a 401(k) profit-sharing plan can generate hundreds of thousands of dollars in annual tax savings. The Pension Protection Act of 2006 established the cash balance plan as a viable and legally recognized retirement savings option. Before 2006, cash balance plans faced frequent legal challenges. Those bringing the lawsuits argued that cash balance plans violated the rules for benefit accrual and discriminated against older workers. The rulings on these cases were inconsistent, and many business owners didn’t want to risk establishing a plan that simply didn’t have firm legal footing. The Pension Protection Act ended this legal uncertainty and set a few specific requirements for cash balance plans, including: • Clarification on age discrimination claims: A cash balance plan does not violate age discrimination legislation if the account balance of an older employee is equal to or greater than that of a similarly situated younger employee (i.e. with the same length of employment, pay, job title, date of hire, and work history). • A vesting requirement: Any employee who has worked for their company for at least three years must be 100% vested in their accrued benefits from employer contributions. • A change in the calculation of lump sum payments: Participants can usually choose to receive a lump sum upon retirement or termination of employment instead of receiving monthly payments. Before 2006, some plans used one interest rate to calculate the anticipated account balance upon retirement but, if a participant opted to receive a lump sum, used a different interest rate to discount the anticipated retirement balance back to the date of the lump sum payment. This led to discrepancies between the hypothetical balance of the account and the actual lump sum payout, an effect known as “whipsaw”. The Pension Protection Act eliminated the whipsaw effect. There are, of course, many other points included in this lengthy piece of legislation, but the takeaway is this: The Pension Protection Act of 2006 removed the legal uncertainty surrounding cash balance plans and made them a much more appealing option for small business owners. According to Kravitz Inc., the number of cash balance plans in America more than tripled after the implementation of the Pension Protection Act. Additional regulations in 2010 and 2014 made these hybrid plans an even better option, and their popularity only continues to grow. There are thousands of highearning business owners who can reap huge, tax-crushing benefits from implementing cash balance plans . . . you just have to know about them first. The most valuable tax deductions are above-the-line deductions that reduce earned income dollar for dollar. These deductions have the exceptional effect of being able to move the taxpayer into a lower tax bracket, thereby significantly increasing his or her tax savings. With combined federal and state income tax rates at around 45% for top earners, finding and taking advantage of the right deductions becomes more important than ever. Cash balance plans provide this kind of dollar for dollar deduction, making them invaluable for many Cash Balance Advisors clients. Cash balance plans belong to the group of “qualified plans” described in Section 401(a) of the Tax Code that hold a tax favored status with the IRS. Most tax advisors strongly recommend that qualified plan options be fully funded before pursuing other tax strategies, as they provide some of the most comprehensive and powerful tax benefits in existence. With a cash balance plan, you have the added benefit of saving not only on the contribution amount, but also on the subsequent earnings generated by the contributions. As an example: a contribution of $130,000 that earns 5% for 30 years would be worth $561,852 at the end of that time. However, if that contribution were taxed at the highest tax rate and the 5% earnings each year were also taxed, the value after 30 years would be only $162,937—clearly a less desirable amount than the first number. Ultimately, these numbers show what I say all the time: cash balance plans are one of the best options for high earners looking to protect their income and grow their retirement savings and should certainly be investigated.