Cash Balance Plans- Pitfalls of Using an Investment Rate of Return as the Plan’s Interest Crediting Rate
In 2015, the IRS released final regulations pertaining to the acceptable interest rates that can be used for interest credits in a cash balance plan. One of these acceptable rates is to allow the plan’s interest crediting rate to equal the investment rate of return on the plan assets. The advantage to such an arrangement is that the plan’s liabilities and plan assets should (in theory) always be the same which means the plan is never overfunded or underfunded. This allows the annual contribution to the plan to be equal to the total of the annual principal credits to the plan participants.
However, there are a number of potential issues that a plan sponsor may face if they use the investment rate of return as the plan’s interest crediting rate. Here are a couple of the most significant issues:
- Passing the nondiscrimination in the amount of benefits test under Internal Revenue Code(IRC) Section 401(a)4. Under this test, annual principal credits are accumulated to the plan’s normal retirement testing age using the plan’s interest crediting rate and converted to a monthly accrual. Using a fixed interest rate for accumulating the benefits to the plan’s normal retirement testing age provides predictability for these accrual rates. However, if the plan’s actual rate of return was 10% for a specific year, all principal credits for that plan year are accumulated to the plan’s normal retirement testing age at 10%. This may significantly increase the accrual rates for the plan participants and could adversely affect the nondiscrimination testing for that plan year.
- Minimum participation testing problems under Internal Revenue Code Section 401(a)26. Under IRC Section 401(a)26, a cash balance plan must provide “meaningful” benefits to at least 40% of the non-excludable employees of the plan sponsor. The IRS defines “meaningful” as a participant whose principal credit converts to at least a 0.5% benefit accrual for the year. To do this calculation, a participant’s principal credit is accumulated to the plan’s normal retirement testing age using the plan’s interest crediting rate and converted to a benefit accrual rate. If the plan’s interest crediting rate defined as the plan’s investment rate of return and this rate is too low, a participant’s accrual rate may be less than 0.5% and may not be counted as benefiting for purposes of this test. If enough of the plan participants do not make the 0.5% accrual threshold, the plan may not pass this test. In that case, plan eligibility would have to be expanded to other classes of participants or benefits would have to be increased to enough of the current plan participants to meet the 40% threshold under IRC 401(a)26.
Cash balance plans continue to grow in popularity as a way to save additional monies for retirement and can create significant tax deductions. Many plans are moving towards utilizing an investment rate of return for their interest crediting rate. However, it is important for plan sponsors that are thinking of utilizing an investment rate of return to be aware of these issues before they implement this approach.
If you have questions regarding this issue, please feel free to contact David Paauwe, MSPA, EA at firstname.lastname@example.org.
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