By Dr. James M. Dahle, WCI Founder
The single best tax break available to physicians is maximizing your retirement plan contributions. Most self-employed or partnered doctors already have a defined contribution/profit-sharing plan (SEP-IRA or 401K) available to them into which they can contribute $58K a year for 2021 ($64,500 if they're 50+.) If your federal and state marginal income tax rate is 37%, you just knocked $21,460 off your tax bill. But what if you want to save MORE of your money toward retirement? You can use a backdoor Roth IRA or even a taxable account, but neither of those reduces your tax bill this year. One option you should consider is using a special kind of defined benefit plan called a cash balance plan.
Two Broad Categories of Retirement Plans
Retirement plans can be divided into two broad categories.
#1 Defined Contribution
A 401(k) is an example of a defined contribution plan, where you contribute a certain amount each year. Depending on investment returns, that initial contribution may grow to be a small amount, a large amount, or even disappear completely. There is no guaranteed benefit at the end. All that is defined is how much you can put into it as you go along. The amount of money you will have to spend in retirement depends entirely on how much you put into the account and the performance of your selected investments. The risk is all on you.
#2 Defined Benefit
A defined benefit retirement plan works differently. The classic example is the increasingly rare company pension. You work for a company or government entity for 20 or 30 years, and after you retire, the company pays you a defined benefit for the rest of your life. The company takes all the investment risk. If the investments do well, the company can get away with putting less money into the account. If the investments do poorly, the company must contribute more to the account. But either way, there is no difference to you. You get the defined benefit.
Cash Balance Plans Are a Hybrid
A cash balance plan is technically a type of defined benefit plan, but it can act like a defined contribution plan in two important ways:
- Depending on how your plan is designed, you can actually change how much you can contribute each year (or if you want to keep your plan administrator happy, every few years) to the plan.
- Upon separation from the employer, or when the plan is closed for any reason acceptable to the IRS, you can transfer the money tax-free into a 401(k) or IRA, just like a 401(k) or most other defined contribution plans.
For most participants, the cash balance plan is essentially an extra retirement plan allowing for additional tax-deferred retirement contributions above and beyond those allowed in the 401(k). Perhaps the best way to think of a cash balance plan is that it is an additional 401(k) masquerading as a pension. It has to follow the actuarial rules that apply to pensions, but at the end of the day, (wink wink nod nod) we all know you're just going to roll it over into your 401(k) in five or ten years.
When private companies were trying to get rid of their expensive pension plans, many of them converted their pension plans into defined contribution plans, transferring the investment risk from the employer to the employee and often lowering the cost to the employer (and the benefit to the employee). However, some companies simply changed their pension plan into a cash balance plan. Employees didn't like this any more than seeing a 401(k) replace their pension, but this concept of a cash balance plan does provide an additional tax-sheltering retirement plan option for a physician or other high income professional.
How Cash Balance Plans Work
A cash balance plan seems complicated because, as a defined benefit plan, it must at least resemble a typical pension. That means the participants in the plan generally select or manage investments in the plan, at least not in the frenetic way that many frequent traders “invest”. The cash balance plan requires complicated actuarial calculations to determine the maximum contributions that can be made into the plan for any given employee. The contributions also must technically come from the employer, not the employee. Due to these complications, fees on a cash balance plan are generally higher than those in a 401(k). Unless you are an independent contractor with no employees (and maybe not even then), this type of plan is not a do-it-yourself project; you will need to hire an experienced company to design and run the plan. Our WCI Recommended Retirement Plan Advisors are pros at doing this and can customize the best plan for your business.
Contributions to the Plan
All contributions into the plan are generally pooled and invested together by the plan trustee. However, hypothetical individual accounts are tracked and credited with a certain amount of interest each year, depending on the performance of the underlying investments.
If the investments perform well, that credited interest rate may be higher up to a certain point, such as 5–7 percent per year. If the investments perform very well, the additional earnings, above and beyond the 5–7 percent limit, are allocated to a surplus account where they can be used to make up for future shortfalls in investment performance or to reduce future required contributions. If the investments perform poorly, the owners of the company may be required to contribute additional money to the plan to make up the losses over a period of a few years.
This aspect of defined contribution plans turns off many physicians (who are generally not only the participants in the plan but also the owners of the company). However, in reality, this mechanism is of significant benefit to the physician. In a market downturn, not only do you GET TO (also admittedly HAVE TO) defer even more money into the plan, but the make-up contributions are also deductible. You are essentially forced to buy low, boosting future market returns. In essence, the company is taking the investment risk, not you. Of course, for many doctors, you are the company, so you're taking it either way.
Example #1: Predetermined Interest Plans
For example, in my old cash balance plan, it worked like this. The money was invested across 8 mutual funds, in a 54%/46% stock/bond ratio. Each year an investment committee (made up predominantly of physicians in the plan) decided how much interest to credit the participants. In the event the investments had little to no return, participants didn't get an interest payment. In the event of a high return, the interest was capped at 6.5% and the rest went into the reserve account. If the return was negative, money was pulled from the reserve account. In the event of a really low return, the company (ie, the physician partners) had to make an extra contribution to the account to make up some of the losses.
While that sucks to have to do in an economic downturn, especially when you'd rather be buying low yourself in your personal accounts, at least by doing so the plan is buying low, which should improve future returns. When you retire or leave the company, you did not get any share of that reserve account even if there had been recent high returns in the plan, but nor were you required to make an extra contribution if the plan has a significant loss the year you separate from the company or partnership.
Under this arrangement, how much more could you have to contribute in the event of a severe market downturn? In 2008 my plan lost 22.8%. First, the reserve account was applied, reducing the net loss to about 15%. By law, that loss is spread over 5 years, so it is divided by 5. The “company” (i.e. the partners in the plan) had to make their regular annual contribution, plus 3% of what they had in their “individual account” in the plan at the beginning of 2008. So if you started 2008 with $100K in the account, and your annual contribution was $10K, the contribution due at the end of 2008 was $10K + 3%*$100K, or $13K. Of course, that entire $13K is tax-deductible. There was also a much smaller contribution due in 2009, but investment gains then put the plan back into a surplus.
Example #2: Plans That Credit with Actual Returns
Some newer cash balance plans credit your account with the ACTUAL RETURNS of the underlying investment(s). My partnership has had three cash balance plans while I have been there. The first one worked as described above. The most recent one essentially allowed me to choose between three Vanguard Life Strategy Funds (Moderate-60/40, Conservative-40/60, and Income 20/80) as far as how much risk I wanted to take in the plan. (If you care, I chose the most aggressive one because it was closest to my overall asset allocation, knowing that I could potentially have to put additional money into the plan in a downturn.) In this case, if the fund makes 12%, I'm credited with 12%. If it loses money, I lose money.
There are lots of options in how the CBP actually works; you should discuss all of them with your retirement plan professional when implementing a new plan and read the paperwork carefully (and ask questions) if you join a practice that already has one in place.
As in a 401K, the money grows in a tax-deferred manner, and you can't access it before age 59 1/2, except for some limited circumstances, without paying a 10% penalty (plus the taxes due).
When you retire or separate from the company, you can either annuitize your “account balance” or you can take it as a lump sum, either in cash or by rolling it over into an IRA or another retirement plan.
How Much Can You Contribute to a Cash Balance Plan?
This is, unfortunately, a really complicated question. The answer depends on how much is in there already and how old you are. It can range from just a few thousand to over $300,000. There's a law that only lets you accumulate up to “an annual benefit” of ~$2.9 Million (2020) into the cash balance plan. So the older you are, and the less you have in there, the more you can contribute. Additionally, the annuitized benefit cannot exceed either the average of your top three years of consecutive compensation or $230,000 (2020), whichever is lower. See what I mean about not being a do-it-yourself project?
In general, you contribute either a percentage of salary or a flat sum (such as $5,000 or $40,000) each year. Of course, if you have employees, non-discrimination testing must be done and you may have to contribute 5-7.5% of their salary for each of them. Many plans, due to actuarial restrictions and top-heavy testing, limit you to much lower contribution limits than what is theoretically possible. My contribution limits have ranged from $15,000 to $30,000 in my plan, but some older members of my partnership can currently contribute as much as $120,000 per year.
Expenses for cash balance plans can be considerably higher than for a 401K plan, because they require an actuary to get involved. For example, one of the plans I had charged 0.2% for the 401(k) and 0.6% for the Cash Balance Plan.
What Are the Downsides to Cash Balance Plans?
It's possible the investments perform poorly for a long period of time and you have to make up the interest payments out of your cash flow. That doesn't seem like a big deal if you have to make up a 5% payment on a $50,000 balance ($2500), but coming up with $50K could be a huge issue if you have a $1 Million balance. If you're not already saving $58K (2021) into a 401K (and probably maxing out backdoor Roths for you and your spouse), then you're unlikely to benefit from a cash balance plan especially given the decreased flexibility and higher expenses which drag on returns. The average physician (making $275K) probably doesn't need one of these plans simply because they don’t make enough money to really benefit from them.
Although the money in the plan technically belongs to the company, not you, the assets must be managed for your benefit and are not subject to the company's creditors. They are also generally protected from your creditors. The pension is also usually insured by the Pension Benefit Guaranty Corporation, a government entity. Your company generally pays $35 per year per participant for this insurance, but may be exempt if there are fewer than 25 employees.
Also, if you're required to make significant contributions for your employees, this can be an additional practice expense, eliminating the personal benefit to you, the owner.
Cash Balance Plans Are a Good Option for Partnerships
Many physicians and dentists incorporate both a 401(k)/profit-sharing plan and a cash balance plan into their practices. Despite the additional expense, the immense tax break available, as well as the asset protection (generally fully protected from creditors, just like a 401K) make them particularly attractive. The flexibility available through the plans is also a huge benefit. Partners can make different contributions, the plan can often be made physician/dentist-only, liability between partners can be managed, and you can scale back on contributions or even amend or terminate the plan relatively easily if cash flows decrease.
Independent contractors without employees can also use this combination of accounts. An individual 401(k) is relatively easy to set up. A personal defined benefit plan is a little more complicated but still widely available from a number of firms at a fair cost. Because you are both the trustee and the participant, you will have even more control over your investments.
There are two other considerations to keep in mind. If your business qualifies for the 199A deduction, remember the cash balance plan contribution counts as a business expense. That means it will lower your ordinary business income and potentially, your 199A deduction. Of course, it is also possible that this deduction actually brings your taxable income down into the range where you now qualify for the 199A deduction. I wish it wasn't that complicated, but unfortunately it is, at least for a few more years until the 199A deduction expires.
Also, if you are a super saver, you may wish to preferentially use tax-free contributions such as Backdoor Roth IRAs, Roth 401(k)s, Mega Backdoor Roth IRA contributions to a 401(k), Roth Conversions, and Health Savings Account contributions instead of making additional tax-deferred savings like a defined benefit plan. This is one reason WCI, LLC doesn't have a Cash Balance Plan. Naturally, you can later convert these dollars to a Roth IRA, but that may not be worth it to you. There are not a lot of these doctors out there (for example, only 8% of my physician partners maxed out their DBP when it had a $30K/year contribution limit) but this audience includes a lot of them.
Bottom Line on Cash Balance Defined Benefit Plans
Cash balance plans are an additional 401(k) masquerading as a pension. Physicians interested in boosting retirement savings and minimizing their annual tax bill should give strong consideration to adding a cash balance plan on top of their existing 401(k) plan. A cash balance plan is a great option for those who wish to save for retirement and are already maxing out their 401(k)s and backdoor Roth IRAs.
What do you think? Do you have a cash balance plan? How does yours work? What is the maximum contribution? Are you making it each year? Why or why not? What percentage of your group is maxing it out? Comment below!