By Paul Sundin, CPA, President of Emparion; A 2022 Platinum WCI Medical School Scholarship Sponsor
By now, you are probably aware of all the advantages of cash balance plans. They are home runs for physicians and other business owners in the right scenario.
A cash balance plan is probably your best bet if your goal is a tax-deductible contribution over $100,000. The contributions far exceed the contributions for other types of retirement plans.
All too often, though, business owners focus on all the benefits, and the pitfalls don't get adequately discussed. While many downsides can be mitigated, you certainly want to be educated. This post will cover the top 10 mistakes people make when setting up these cash balance plans. Hopefully, you won't make any of these mistakes when you set up yours.
But first, I will provide some background.
What Is a Cash Balance Plan?
When business owners first consider retirement plans, they often choose a 401(k) or a SEP IRA. These plans are great options but come with low contribution limits for high-income business owners.
There are two broad categories of retirement plans: defined benefit plans and defined contribution plans. A cash balance plan is a type of defined benefit plan, and a 401(k) is a type of defined contribution plan. Defined benefit plans aim to generate a benefit upon retirement. Defined contribution plans specify a maximum contribution limit upfront.
Cash balance plans can provide a retirement benefit of up to $3 million. Because of how the contributions are calculated, the plans do not have the annual limits associated with a 401(k) or SEP. As such, they allow much larger contributions that increase with age and compensation.
Like 401(k) plans, cash balance plans work great for owner-only businesses and small companies. But they are a little more complex to administer. The plans need to be established by a third-party administrator and reviewed at least annually by an actuary.
How Do Cash Balance Plans Work?
Cash balance plan participants receive an annual contribution. Each employee has a hypothetical account balance similar to a 401(k) or a profit-sharing plan. The actuary tracks these accounts.
Employee accounts grow in two specific ways:
- A pay credit: This can be based on a percentage of pay or a flat dollar amount specified in the plan document; and
- An interest credit: This is a fixed or variable rate independent of the plan's investment performance.
Even though you can make much larger contributions to a cash balance plan than a 401(k), annual contributions come with a target, minimum, and maximum. You have some flexibility in your yearly contributions.
Now that you understand the basics, let's explore my top 10 mistakes and discuss how best to structure a plan. Let's dive in.
Top 10 Mistakes for Cash Balance Plans
#1 Not Considering Prior Service Allocation
When you initially set up a plan, you have some advantages. Depending on how long you've been in business and your compensation levels, you can frontload a plan and make a substantial contribution in year 1.
One of the ways to make this larger first-year contribution is to “pull in” compensation from prior years. Essentially, the plan states that all eligible employees will get an initial plan credit for services previously provided. This allows you to make a year 1 contribution that covers several years.
Another added benefit is that you can amortize this prior service portion over seven years. This will give you funding flexibility in the first several years of the plan's life. That way, you can take advantage of the time value of money upfront.
#2 Max Funding Other Retirement Plans
Thanks to recent IRS changes, you can now open up and fund a cash balance plan before filing the tax return for the previous year. Many people establish and fund these plans in the summer or fall months for the preceding year. They aim to contribute just before the tax return filing deadline.
But one problem often comes up. With all the benefits of cash balance plans, they can be challenging when combined with different retirement plans. In fact, the combination rules will limit or restrict funding for other plans.
Cash balance plans will typically combine well with a 401(k) plan. However, profit-sharing contributions are reduced to 6% of deemed compensation. Many people will fund the maximum 25% profit sharing for the 401(k) plan and think they can layer a cash balance plan on top. But if you've fully funded a 401(k) plan, your cash balance plan funding will be substantially limited.
In addition, many clients will come to us when they have already funded a SEP plan. SEPs are prevalent retirement structures because the IRS has always allowed them to be opened up and funded just before the tax deadline. But the problem is that they don't combine well with a cash balance plan.
SEP plans fall into two categories: (1) model SEPs; and (2) non-model SEPs. Model SEPs cannot be combined with cash balance plans. But non-model SEPs can be combined. However, they are still subject to the 6% contribution limitation.
Clients often come to us after they have max-funded other plans and don't realize there are rules when combining them. I always tell clients that if they are considering setting up a cash balance plan, they should not fund any other retirement structures until they decide on their retirement plans.
#3 Not Understanding Plan Permanency
Most clients are looking for a plan that they can fund until retirement. But some people are just looking for a significant contribution for a year and then want to terminate the plan.
The IRS clearly states that these plans are permanent. But that doesn't mean you have to have them open forever or for the remaining life of the company. The IRS says you should have the plans open for at least several years.
What does “several years” mean? It's tough to say because the IRS did not specify a threshold. But needless to say, these plans should have permanent intent. It should be something that you're looking to have indefinitely.
But just because you have long-term intent does not mean you must have the plan open forever. Businesses can change and evolve. You can certainly terminate a plan if circumstances change and your financial situation deteriorates. In fact, many business owners had to terminate their plans due to COVID. I think the IRS understands this. But still, the goal is to have long-term intent.
#4 Don't Consider Higher Fee Structure
You're probably aware that cash balance plans carry relatively high fee structures. This is because of the required actuary certification.
But these plans have other factors that make them more complex to administer. Since they are defined benefit plans, you are not dealing with standard annual contribution limits. You receive a funding range that depends mainly on your age, compensation, and investment returns. There just are more tasks for the administrator to do.
Depending on plan structure and number of employees, setup fees typically range from $1,000-$2,000, and annual administration will usually run from $2,000-$3,000. So, if you're looking only to contribute $20,000-$30,000 into retirement, stick with a 401(k) or another type of defined contribution plan. If you're looking for contributions of $100,000 a year or more, you will need a cash balance plan.
#5 Putting All Funds in Stocks or Volatile Assets
You're probably aware of how volatile the stock market can be. Cash balance plans don't like volatility. One of the biggest mistakes you can make is not understanding investment options and how they impact the plan contributions.
First of all, your plan most likely has a fixed interest crediting rate (probably around 5%). This means the plan assets have an assumed return of 5%, and the actuary will model contribution levels using this rate. As such, the plan's goal is to mirror this rate generally.
Most physicians and high-income business owners seek consistent annual contributions to lower taxable income. That's why they want to ensure that they invest plan assets conservatively.
Significant investment gains and losses lead to funding volatility. This leads to large swings in annual required contributions. I recommend using a conservative investment approach with a mix of stocks, bonds, and other non-volatile investments. An investment allocated 100% to stocks is not recommended.
If you desire more stock market exposure, please consider increasing stock allocations in IRAs, 401(k)s, and other defined contribution structures. This way, you can have an aggressive portfolio in your IRAs and defined contribution plans, with a conservative mix in your cash balance plan. Overall, you can adjust your retirement plans to maximize your portfolio allocation.
Just because you can manage your investments does not mean you should. If you are uncomfortable managing these investments, you should consider using a financial advisor that is familiar with these plans.
#6 Don't Forget About Mandatory Contributions
I'm guessing you heard these plans have mandatory contributions. This isn't 100% accurate, though, because we often see people frontloading plans with high early plan year contributions. People often take advantage of the time value of money and its relation to investments and tax deductions.
You may find that if you aggressively fund the early plan years, you might not have a mandatory funding requirement for a given year. In fact, you're given a target contribution each year, but you also have minimum and maximum funding levels.
Most high-income clients don't have a problem with mandatory contributions. But sometimes, you'll see situations where business is down. A company loses a contract or other conditions that can lead to cash-flow problems. In fact, we have seen people not wanting to fund a plan because they were going to buy a new Ferrari or build a new house. We even had one client whose medical practice burned down.
I understand that people can have funding issues. But remember that these plans are permanent, and you must ensure adequate funding to cover annual minimum contribution requirements.
If you can't make a minimum contribution, there will be an excise tax penalty. But you do have several options before an excise tax is imposed. In addition, you have the flexibility of when you can fund the plan. Make sure you communicate any funding concerns ASAP to your administrator.
#7 Not Customizing the Plan
Many clients fail to realize that these plans are highly customizable. The goal is to ensure you get the largest contribution and tax benefit in the year you want. If you have employees, the aim in most situations is to limit employee allocations. An owner contribution of at least 85% is generally the goal.
But there are many ways to customize these plans to work for you. Some of the customizations include:
- Using a “tiered” structure with additional pay credits for different compensation levels.
- Frontloading a plan or keeping allocations low for a couple of years and then opening up funding for a maximum contribution.
- Maximizing owner allocations while limiting employee allocations by only providing employees a “meaningful benefit.”
- Giving employees a percentage of pay or even a flat dollar amount.
When setting up a plan, ensure that you discuss plan customizations and tailor the plan to your specific needs. Get the right structure upfront to avoid problems down the road.
#8 Poor Communication
Communication is critical in business relationships. Certainly, some plan administrators don't do their best when communicating with clients. Many specialize in 401(k) plans and have limited knowledge of defined benefit plans, so they have to outsource to an actuary.
But poor communication can work both ways. You often see that clients do poorly communicating with administrators. Sometimes this is because they're not very familiar with the plans and how they work.
Let's face it: I estimate that over 90% of financial advisors and tax professionals don't understand these plans. It is imperative to ensure that all parties understand how the plan is structured and that they can freely communicate about the plan design.
#9 Overfunding Plan
You may have heard that overfunding cash balance plans can be a problem. It can. Many people get very concerned about overfunding. But there are ways to mitigate it.
The IRS allows a maximum amount in these plans of approximately $3 million per individual (and per control group). This gets indexed each year upward, so the maximum continues to grow.
Accumulating $3 million in a plan might seem like a challenge. But, considering the investment mistake noted above, if the plan is invested heavily in stocks or any speculative investments, you might hit that number sooner than you thought.
So, what happens when a plan gets overfunded? When an overfunded plan is terminated, the IRS assesses a 50% excise tax penalty on the overfunded balance. If that's not enough, the entire overfunded balance is subject to reversion. This means the overfunded amount comes back as income to you or the business entity. You could see yourself spending 40%-50% in tax (depending on the state you live in). Essentially, you lose the entire overfunded balance.
This sounds somewhat harsh. I see clients concerned about this in the early years when a plan is set up. But overfunding is typically not an issue. You'll get a little funding flexibility early on. However, you can have problems if you continue to fund aggressively and get high asset return rates.
Thankfully, there are some strategies that can help avert or mitigate overfunding problems. It comes back to communicating with your administrator if you feel that your balance is getting a little high. You will generally know because your annual contribution levels will tend to decrease over this period.
At the end of the day, very few people will have to worry about reversion and paying an excise tax. Careful planning can be done to minimize the impact of any overfunding.
#10 Not Doing a Complete Tax Analysis
Did I mention that most CPAs don't know how these tax plans work? When considering a plan, you should work with your CPA to correctly calculate the plan's tax impact. You must first take your marginal tax rate (the tax that each next dollar is taxed). Then take the planned contribution and reduce it, possibly going down into a lower tax bracket.
In addition, you want to make sure you consider state taxes. State tax rates vary across the country. In addition, a few states don't give you a tax deduction for your contribution. They also don't tax pensions when you take the money out.
Reflecting the tax deduction on an S-Corp or C-Corp tax return is generally not that challenging. But it's certainly more complex for a sole proprietor or partnership.
I often see CPAs taking the deduction directly on Schedule C for a solo plan. However, the deduction should actually be taken as an adjustment to income, and Schedule C should only reflect employee contributions.
Make sure you and your tax professional carefully review the plan so you're educated on your actual tax savings. The amount should be properly reflected on your tax return to avoid any IRS issues.
If you think a cash balance plan is right for you, ensure that you consider not only the pros but the cons as well. Proper upfront planning with all parties is imperative.
What is our favorite plan structure? We like to use prior service, flexible funding ranges, and conservative index investments. But most importantly, our favorite structure mitigates all the mistakes listed above.
Cash balance plans are powerful retirement tools and should be considered by most self-employed physicians and other high-income business owners. Hopefully, you won't make any of these mistakes when setting up your plan.
[Editor's Note: Many thanks to Paul Sundin and Emparion, one of our Platinum Level (contributing $8,000+) Sponsors for the WCI Medical School Scholarship, and their relationship with WCI and helping physicians and other high earners with strategic retirement services. This is the first of our five scholarship-sponsored posts for 2022. Emparion's strategies include cash balance plans, defined benefit plans, 401(k)s, and other retirement vehicles, and Paul's goal for the past 25 years has been to educate clients on retirement strategies, tax strategies, and personal finance. Thank you for supporting those who support this site and especially the scholarship. All proceeds go to the scholarship winners.]
We work with many clients on retirement plan strategies and have subject matter experts around the country with deep knowledge of cash balance plans. I think you hit on the major points, very good educational piece I will use.
You didn’t mention the use of life insurance in these plans. Many clients have found it to be valuable for maximizing contributions, controlling the overfunding concerns, tax deducting premiums, and returning some of the retirement benefit tax free. It is not for everyone but should be part of the analysis. Look at pros and cons.
Ugghhh….yet another way to sell docs life insurance they don’t need. Sounds about as dumb as putting annuities in an IRA. You’re paying twice for the tax protected growth not to mention additional fees and commissions.
You are right on Jim. ITs ACTUALLY much worse than that though. First lets explain again how defined benefit works. You can get a maximum benefit which for lump sums is around 3.1 million dollars. The reason why 412i/e plans that have insurance have the highest deduction…because they have the poorest return. So by purchasing a plan with permanent insurance in it, you have paid the very most for the same defined benefit. But it keeps going. The death benefit is no longer tax free. It is owned by the plan. And yet it still gets worse than that. It can NOT be transferred to an IRA so if you change your business or retire or whatever, then you are really screwed. You have to either buy it out of the plan all at once for the greater of the PERC of NITR value which means if it still has a low cash value like usual then you have to pay the amount of all premiums paid and this is with after tax money. This is in essence a huge hit all in the same year or surrender it and never get the death benefit you were paying for with those crapyp returns. Very few 401ks accept it as well (only ones run by insurance companies for the most part) so good luck transferring it one of those unless you want to keep dealing with the same insurance company that sold you the plan. The costs that these insurance companies charge for their plans in particular 401k are also very high and for the 401k piece have crappy investments to boot.
Permanent insurance is a very poor investment and the absolute worst way to purchase it is within a defined benefit plan. Think of everything bad you ever heard about permanent insurance and times by 3.
Let me be clear, I am not recommending life insurance as an asset in the cash balance plan. I was simply asking of your knowledge of people recommending, It seems you’re not aware of strategies like this. I too, don’t see the advantage of a tax deferred product inside a tax shelter, however, an ERISA tax lawyer, from one of the major firms, proposed this strategy, using life insurance inside the plan, to produce tax free income. The concept seems to be well documented with IRS Codes and from a top law firm. Just asking if you are aware of such a strategy and have an opinion. Like you, I am suspect of advisors selling real estate, investments, and insurance without a lot of transparency. That is why we are fee only and don’t sell products.
I’m unfortunately very very familiar with it.
You might want to know that several [email protected] carriers stopped covering for 412i/e plans.
It isn’t tax free income while owned by the plan by the way. It’s very expensive to remove it. Might want to research PERC values. You are going to find many unhappy clients down the road when they realize that the high contributions don’t result in a larger pension benefit and what it costs to get out of this mess.
Interesting, I wonder why a leading law firm would issue an opinion letter opining on the concept? The strategy they outline is to buy the policy from the plan in the future. It is complex to understand for most. Also a conservative life insurance company, who turns down many concepts, also allows it? Does PERC values only deal with the value of the policy when it comes out? I’m not trying to sell this, only understanding your comments for a better understanding as I see the law firms views but want to hear the pros and cons. .
Well what is the law group qualified to do? They are qualified to determine if its legal and of course it is. These plans are not new. They have been around for decades. Its perfectly legal to sell people this junk. Why are they giving you a legal opinion now on a product that’s been around for multiple decades? Because someone has paid them to do so. That would be a waste of money for someone to pay for an opinion since its been legal so long but…. by doing so it generates interest by people like you. You don’t know about it. Guess what, there is a good reason you haven’t heard of it, its terrible for your clients. These lawyers aren’t fiduciaries and likely don’t even understand the alternatives or the math behind it all.
Lets go over how this is sold….Hey Dr Smith, we have this 412i/e plan that you can contribute and deduct twice as much as you could with a regular DB or cash balance plan. Wouldn’t you like to save more on taxes this year? Dr. Smith unfortunately says yes bc he or she doesn’t realize that contributing more results in ZERO additional benefit. What isn’t told to the client, is hey Dr Smith if you chose this 412i/e plan than you are in essence paying twice as much to get the same benefit as a cash balance or regular DB and you will have more money in your pocket this year even when including the additional taxes you will pay this year. And to boot there are serious costs with getting out of this mess and in all likelihood you will never get the death benefit you paid so much for. Mose people don’t initially get that putting twice as much into a DB plan isn’t going to do better since with a 401k it would do double the benefit.
Lets go over a made up example. If you have a 412i/e plan and you fund it with lets say 200k per year for 10 years bc you want to retire then or as like most plans trying to close after 10 (some of course even try 5). You put 50% into whole life (the max you can). This creates the highest commission for the agent as well so its what is usually recommended. So after 10 years you have put about 1 million into WL. You decide to exit the plan. Here are your options now for the WL part…You can surrender the WL inside the plan. It very likely has less than 1 million in CSV. You lost money over a 10 year period. Not a great investment and you paid for a death benefit you have lost. 2nd option. You distribute the WL from the plan assuming you are 59.5 or greater. Whatever the total amount of premiums you paid (PERC value) is or the current CSV if it happens to be more, will be the amount coming out so 1 million dollars and you now have a tax bill for 1 million dollars of income in addition to whatever other income you have that year. Your actual pension amount of what is left over is seriously reduced. You can now start taking loans to get the tax free nature and pay all those loan fees for the rest of your life (it’s a lot). Taking loans early in retirement is always a bad idea with WL. 3rd option. You buy it out of the plan. This way the “real pension value” is made whole. You have to use the same cost valuation so yes PERC is a value used with life insurance with pension plans. If they say you can spring it out for less than the greater or PERC or net interpolated terminal reserve (sort of like the cash value) then they don’t seem to actually know the rules. Last option is to roll into their 401k since nobody else takes these and you cant roll it into an IRA. Besides huge fees and terrible investments within the 401k that you are keeping, you are now kicking the can down the road. All Horrible. Very few have the money or desire to buy it out in retirement or even take the tax hit without serious issues.
These people always say for the right client but the right client is a sucker who trusts the company to do whats right. 412i/e are horrible and the only possible use is with 100% annuities with a very short time horizon in someone who takes zero risks. Everything else is smoke and mirrors. You say you see the law firms view but you wont post them in detail here bc its gonna be clear it doesnt actually favor the client.
Hard to get excited about a retirement plan that requires me to buy a life insurance policy from the plan in the future. Insurance isn’t free. There’s a cost to it. And buying unnecessary life insurance generally doesn’t work out well.
When talking about any defined benefit plan to doctors, you sort of need to split between solo or very few member plans and larger groups. There seems to be a significant number of solo plan docs (like myself). When thats the case, you SHOULD overfund it and you SHOULD use mostly stocks assuming you have some confidence that you wont be merging/closing the plan in the next few years. Overfunding early on gets rid of problem number 2 because then you dont fund at all in the other years. When overfunding your goal should be to have zero contributions to the defined benefit plan in years you are not contributing so you can completely max out the 401k/profit sharing. I haven’t contributed to my defined benefit plan in probably over 5 years because of returns (that of course might change). This has allowed me to fully max out the 401k/ps. Also if i happen to have losses bc of my market risk, the government now fully participates in that and ALLOWS me a “second, third, fourth” chance. If for some reason my finances go to hell and i cant cough up the money again, then i just amend my plan for a lower benefit. They dont let me have a redo in my 401k if investments go bad. You have multiple years to make up shortages, not just one. This kind of strategy works when its just you or you and a few very close friends/family. It is pretty risky when its a big group especially if you have folks of various ages but its important to understand that defined benefit cash balance or otherwise is different than defined contribution plans. You cant get more than the 3.1 million or whatever it is in the future and thus every dollar you place into the plan is just your cost to get to 3.1. I prefer for that benefit to cost me less.
Hi Rex,
I believe I am in a similar situation but in your scenario, if you overfund early on don’t you lose the tax benefit every year from contributing to the plan? Then you are just paying fees for the fund to run yearly without any benefit.
I wouldn’t say without any benefit, but yes, you pay fees every year. It may reduce future contributions which does reduce a benefit of the plan, but I’d say the increased value offsets that.
Paul, thanks for this post. I’ll be eligible for my practice’s plan in a couple of years and want to understand a bit more about DB plans. Regarding the prior service allocation, can you elaborate a bit more on the mechanics of this? For example, I’m a young doc starting my third year of practice with my current group. Would I be able to count towards my first year’s contribution the income I made in previous years with the group? Also, what do you mean by amortizing the payment over several years. Are you saying that I could take the tax advantage in the first year but spread out contributions over subsequent years?
Based on your biased comments against the use of insurance in a plan, I did reach back out to the law firm and the two actuarial firms who have used such a strategy. These actuaries are very conservative people who I trust are doing the right thing for clients. You indicted that everything is in the Code legally. Just to be clear again, we don’t sell or push any product and have no bias for any funding vehicle. We simply do an economic analysis to compare various strategies and have found this to work for some clients, not all. I don’t like to see retail, high commission products by salespeople just pushing the concept, as you indicated. We are able to catch these situations with a true economic analysis. I rely on the economics and the black and white nature of the IRS Codes. This is not a 412i/e 3 product like you indicated in your response, I don’t like that approach either. According to the actuaries these are products with very low commissions, sometime basis points, designed specifically for qualified plans. I think we have beat this topic up enough, bottom line you must do your homework and get unbiased and unconflicted advice when looking at any strategy. This post is an excellent example of pointing out areas of concern and design options that people should consider. Thanks for sharing your input.
Even if it is just a DB plan that has insurance and other investments, the issues are EXACTLY the same. The high contribution is nothing more than tricking people to think they get more which they don’t and the distribution is problematic at best.
Like I said, you won’t actually produce the “evidence” that it’s a good idea and you have no legitimate rebuttal to my statements. So I’m sure you do want to end this conversation.
For #5, you said “I recommend using a conservative investment approach with a mix of stocks, bonds, and other non-volatile investments. An investment allocated 100% to stocks is not recommended.”
Which conservative funds do you recommend for a cash balance plan?
I totally agree with your comments as it relates to 412i/e 3.
So any responses from the author or WCI to the questions above?
I don’t know the answer to your questions Dan. You can book a call with Emparion at the link at the top of the post. Or contact one of the other recommended retirement plan experts found on this page:
https://www.whitecoatinvestor.com/retirementaccounts/
Question regarding a straight defined benefit plan versus a cash balance plan. I am a W-2 employee who makes high 6 figures income from that. I max out 403B, 457, backdoor roth for my wife and I, and also max out a DCP mega backdoor. Along with my W-2, my device consulting and royalties are will be greater than $500K in 2023 and beyond. I am being told by my accountant and a pension consultant/actuary to do a straight DB plan. My S-corp will just be my wife and I and we will have a 401K in it as well for my wife with employee and employer contributions. I am being told there isn’t really any difference between the two types (DB vs CB) for my situation. From your opinion, is this correct? I get confused trying to distinguish between the two.
Sounds weird. I’d get a second opinion from one of these folks:
https://www.whitecoatinvestor.com/retirementaccounts/
If there’s no difference, why NOT do a cash balance plan? I mean, do you really want a true pension benefit? Probably not. You just want another big fat 401(k) masquerading as a pension.