Cash balance plans and 401(k)s are both employer-sponsored retirement options, but they work differently. A cash balance plan is a type of pension that promises a set payout at retirement based on a formula, while a 401(k) depends on how much you contribute and how your investments perform. The choice between both affects your savings growth, retirement income and flexibility in managing your money.
A financial advisor can help you compare retirement plans and decide which best supports your goals.
How a Cash Balance Plan Works
A cash balance plan is a type of defined benefit retirement plan that blends features of traditional pensions with those of more familiar 401(k) accounts. Unlike a 401(k), where the account balance depends on investment performance, a cash balance plan promises a specific benefit at retirement, calculated using a set formula. Each year, the employer credits a participant’s account with a percentage of their salary plus a guaranteed interest rate, making the growth of the account more predictable.
The handling of contributions and interest are distinguishing factors of cash balance plans. Employers make annual contributions to each participant’s hypothetical account, typically based on a percentage of the employee’s pay. In addition to these contributions, the plan guarantees an annual interest credit, which is not affected by market fluctuations. This means employees can count on steady growth in their retirement savings, regardless of how the stock market performs.
Vesting schedules in cash balance plans determine when employees gain full ownership of their account balances. Many plans use a three-year cliff vesting schedule, meaning employees become fully vested after three years of service. Once vested, participants who leave the company can take their account balance with them, either as a lump sum or as an annuity, making these plans more portable than traditional pensions.
At retirement, participants in a cash balance plan can typically choose between receiving their benefit as a lump sum or as a series of monthly payments for life. The lump sum option allows retirees to roll over their balance into an IRA or another qualified retirement plan, providing flexibility in managing their retirement funds. The annuity option, on the other hand, offers a steady stream of income, similar to a traditional pension.
How a 401(k) Plan Works
A 401(k) plan is an employer-sponsored retirement savings account that allows employees to save and invest a portion of their paycheck before taxes are taken out. Contributions are typically made through automatic payroll deductions, making it easy for workers to consistently build their retirement nest egg. The money in a 401(k) grows tax-deferred, meaning you won’t pay taxes on your contributions or investment gains until you withdraw the funds, usually after reaching retirement age.
One of the most attractive features of a 401(k) plan is the potential for employer matching contributions. Many companies will match a percentage of what you contribute, up to a certain limit, effectively giving you free money toward your retirement savings. This can significantly boost your account balance over time, making it important to contribute at least enough to take full advantage of any match your employer offers.
Within a 401(k) plan, you typically have a range of investment options, such as mutual funds, stocks and bonds. You can choose how your contributions are allocated based on your risk tolerance and retirement goals. Over the years, your investments have the potential to grow through compound interest, which can help your savings accumulate faster than with a traditional savings account.
A key benefit of a 401(k) plan is its tax advantages. Traditional 401(k) contributions are made pre-tax, reducing your taxable income for the year. However, when you withdraw funds in retirement, you’ll owe income tax on those distributions. There are also Roth 401(k) options, where contributions are made after-tax, but qualified withdrawals in retirement are tax-free.
It’s important to note that early withdrawals before age 59½ may incur taxes and penalties. As such, you’ll ideally reserve these accounts for long-term retirement planning.
Key Differences Between 401(k) vs. Cash Balance Plans
Both 401(k) and cash balance plans offer valuable benefits, but work in different ways. The key differences between them can help you see which option fits your financial goals, comfort with risk and career plans:
- Contribution limits: 401(k) plans have lower annual contribution limits compared to cash balance plans.
- Funding responsibility: In a 401(k), employees are primarily responsible for contributions, with employers potentially matching a portion. With cash balance plans, however, employers entirely fund them, making mandatory annual contributions based on a predetermined formula.
- Investment risk: 401(k) participants bear all investment risk, with account values fluctuating based on market performance. Cash balance plans shift this risk to employers, guaranteeing participants a specific benefit regardless of market conditions.
- Plan structure: 401(k)s are defined contribution plans, where the final benefit depends on contribution amounts and investment performance. Cash balance plans function as hybrid defined benefit plans, promising a specific account balance at retirement through annual “pay credits” and “interest credits.”
Benefits of Using Multiple Retirement Accounts
Many people believe that saving for retirement means sticking to a single account. However, diversifying your retirement savings across multiple accounts can offer significant advantages. By using different types of retirement accounts you can maximize your tax benefits, increase your investment options and create a more flexible withdrawal strategy for your future.
One of the primary reasons to use multiple retirement accounts is to take advantage of tax diversification. By balancing contributions between these accounts, you can better manage your tax liability both now and in retirement. As a result, you will have more control over your income and tax bracket in your later years.
You may also enjoy greater flexibility when it comes time to withdraw your savings. For example, Roth IRAs are not subject to required minimum distributions (RMDs) during the account holder’s lifetime. Traditional IRAs and 401(k)s, on the other hand, are. Meanwhile, cash balance plans offer the option of a lump sum or reliable monthly payments.
Bottom Line
The key differences between a cash balance plan and a 401(k) can shape your retirement strategy. When choosing, consider your financial goals, risk tolerance and job situation. Some people use both plans to boost savings and gain tax benefits. A financial advisor can help you decide which option or mix works best for your retirement.
Retirement Planning Tips
- A financial advisor can help you determine when is the best time retire and manage other factors to maximize your benefits. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- If you want to know how much your nest egg could grow over time, SmartAsset’s retirement calculator could help you get an estimate.
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