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.
Watch Expenses
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.
Advanced Thoughts
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!
WCI, any update on your new cash balance plan? I’d be interested in who administers the plan, the actuary you use and the fees for the advisor, administrator, etc. total breakdown of startup and ongoing costs/fees for both the group and individual. FYI, we are a 10 physician practice with about 50 employees based in the same state as you and looking to start a plan this year. We already have a profit share and safe harbor 401k. Any suggestions as we go through the process of setting up a cash balance plan?
The first thing to do would be to see whether you even should have a CB plan and what the employer contribution (and cost) will be. This is typically done by an actuary working together with an adviser (who is acting on your behalf and is not trying to sell you a plan). The actuary I work with charges $400 for an illustration (which is credited towards his fee if he’s hired to design the plan), and that should be the first step. Part of this work involves doing a design study, as there can be many ways to design a plan, so this is where I typically get involved to coordinate the study and communicate with the actuary (they can be a little difficult to work with).
It is important to work with an adviser/actuary who are independent of each other, because if you come to a bundled company that sells Cash Balance plans, they’ll gladly give you a design and there will be nobody on your side to advise you whether this design and/or plan arrangement is actually the best (and the most cost effective) solution for your practice. Not every practice is a good candidate for a CB plan, but once someone has your attention, they might not want to see you go (which can be a bad idea as you do not want to end up closing the plan, since that can get expensive and time consuming).
Then you might want to hire a separate TPA who will help administer the plan. If you want to hire an adviser for your plan, you’ll definitely need an adviser who is a fiduciary to manage plan investments according to a customized investment policy statement. For a larger practice, the most important thing after hiring a good TPA and actuary is to hire an adviser who is an ERISA 3(38) fiduciary, and is compensated by a flat not an asset-based fee. A typical bundled provider or an investment adviser providing services to retirement plans will charge you asset-based fees for their services, and this is especially true for the bundled providers who specialize in working with doctors/dentists (and who charge an arm and a leg for services you can get better and cheaper elsewhere).
Number one thing that your adviser will do is to help you completely avoid all asset-based fees in favor of an open architecture platform that gives access to low cost index funds (such as those offered by Vanguard). Number two, your adviser will help you find the best design for your practice, and number three, they’ll help you find the best vendors (such as TPAs and actuaries). Many bundled providers will try to sell you their record-keeper services for the plan, while in reality you don’t need anything of the sort – a single pooled account at Vanguard will work just fine as the custodian, and you’ll pay no fees, and have access to all of Vanguard’s best funds.
MedAmerica will be the administrator, but no updates yet. We’re still in the processing of closing the old one and probably won’t open the new one for months. I won’t fund it for 12 or 13 more months.
Several of my recommended advisors do this sort of thing, such as Konstantin Litovsky. You might get a quote from him. You might try these guys too.: whitecoatinvestor.com/step-by-step-process-to-improve-your-practice-retirement-plan/
How many years was your old plan open for? If you start a new plan, does that reset the $2.5M limit back to zero?
Unfortunately, you only get a single $2.5M limit (that is indexed to inflation, I believe).
Yes, but if (as WCI said) he closes his cash balance plan, transfers the money to an IRA, and opens a new cash balance plan, how would anyone determine when he reaches the limit?
Its an honor system, just like filing your taxes. It is the law, and you can not have more than the lifetime maximum allows – your actuary (if they are doing their job) will make you close the plan. You have to give your new actuary the old plan information, and they have to track everything adequately. If you get audited, the penalties can be severe.
The maximum lump sum you can rollover from a Cash Balance Plan has increased to just over $2.8 million in 2018. It is important to note that the $2.8 million is available at age 62.
The $2.8 million lump sum is reduced for each year prior to age 62 (i.e. if you terminate the plan and you’re age 50, the maximum lump sum you can roll over will be a lot less than $2.8 million).
10 or 15.
I’m not sure. Probably not, but I wonder if anyone is really keeping track.
Konstantin, how can I contact you?
My email is [email protected].
https://www.whitecoatinvestor.com/financial-advisors/
just wondering if the cash balance plan is the same thing as a cash management account?
No.
It is similar to a Defined Benefit (or a pension) plan.
Is the $2.5M limit a limit to the total amount of money you can accumulate in the plan or is it a limit to the total contributions you can make?
It is a lifetime maximum in your DB/CB plan accumulations, which include investment growth. This number is indexed to inflation, so it slowly grows over time.
So what happens once your accumulated balance reaches $2.5M? If you have any investment gains beyond that (plus inflation), do you have to give them back?
You would have to discontinue contributions and terminate the plan. If you work for an employer, they’d have to discontinue contributions. The exact timing will be taken care of by the actuary – this is a much more involved plan than a 401k, so every year the actuary does the calculations, so they’ll definitely let you know ahead of time whether your plan is about to close.
So if there were multiple participants in the plan, you would have to close it when the first participant accumulated $2.5M? Doesn’t seem fair to the other participants, although I guess they could start a new plan without including the rich guy.
If plan participants are partners or HCEs, most likely the plan is not closed, just the participant is prevented from making further deferrals, unless the participant is the practice’s sole owner, in which case the plan is closed. If there are two or more partners, the plan can stay around. Makes no sense having a plan with 100 docs if a single one maxing out will close the entire plan!
Would a defined benefits plan limit my Profit Sharing contribution in my circumstance. I am 37 years old. Many calculators estimate a DB contribution of $41,000 per year. I make 500k to 600k. At first I thought I could contribute 18k employee plus profit sharing of 6%. Then I saw that the total deductible limit for the two could equal up to 31% of compensation. If the latter is true, then 94k (41k plus 53k) would be less than 31percent and allowed. Am I right?
Does your plan allow you to contribute $53K? Why not ask your plan administrator or read the plan document?
Yes, you are limited to 6% profit sharing in a non-PBGC plan. I’m not sure what calculators you are using. The formula can be different depending on the type of plan design you want (which would depend on your retirement age among other things). I’d have an TPA/actuary make the calculation for you. Also, it doesn’t matter how much you make since only $265k is considered for your plan contribution. According to several websites, your maximum CB contribution is around $68k. If you add another $18k to it, and 6% of $265k, the total is around $100k or so, thus it looks like $94k is not far off. By the way, if you have a spouse on the payroll, you can add another ~$40k into the plan for the spouse as well.
Hi, quick question. In January 2015 you were talking about a new cash balance plan and said…
“The new plan does have some nice upgrades though. The old plan limited us to a return of 0-6.5%. The new plan will basically just pay us what we earn.”
I am trying to set up a cash balance plan in addition to my practice’s 401k with profit sharing. My actuary has said they don’t understand how to pay what you earn — i.e. it has to guarantee a certain return. Could you elaborate on this please?
Right, this is another way of crediting returns – you credit the actual return (or loss) of the underlying investment, so if you have a 20% return, that’s what is credited, and if there is a 20% loss, the loss is ‘credited’. As you can see, that’s not a good approach because that is basically a way to allow money managers to invest as aggressively as they like without having to deliver a steady return (which is very difficult in the low interest rate environment), but this won’t help a bit with getting a steady fixed return that’s necessary to avoid under- or over-funding. You’ll still be underfunding and overfunding with this approach. So having a 6.5% return is not a walk in the park anymore – even that might require a very heavy dose of equities (with resulting underfunding in case of a market crash). What’s necessary is having a low enough rate of return that can actually be achieved without having to go heavy into equities. By the way, a good actuary should be aware of this method and should be able to advise you on its pitfalls.
I don’t have the plan document available to me right now and the last time I talked about it was at least a year ago, so I can’t remember the details right now. But there was a change in the crediting method. When I see the document I’ll try to remember to post the details here.
I am a one physician and 2 extenders practice w/ a 401(k)-profit sharing-Cash Balance Plan. It is being administered by MS for the past 5 yrs or so. Am looking to move the plan d/t lack of transparency on its costs/fees. I just came across a 401/PS integrated service provider named BenefitGuard . They use TD Ameritrade as the custodian and low cost MFs from Vanguard and or DSA. I would still need to engage the services of an actuary for the CBP.
From our 1st tel. conversation it appears that: (at least for the 401(k)-PS
* Custodian fees= 0.18% AUM
*Annual base fee=$2,500
*Investment Manager 3(38) fiduciary=0.2% AUM
I am hoping for any feedback regarding any experience w/ this company or the costs associated w/ their services.
Who will be managing the CB plan investments? This is the more complex task that would require a discretionary ERISA 3(38). If you have any employees, you don’t want to touch this money yourself. Also, who would be coordinating 401k investments and CB plan investments? Will there be an investment policy statement for both plans? It does not sound like you will get any service for the CB plan, and most providers tend to charge high asset-based fees for that.
Depending on the amount of assets you have, you might be able to benefit from having 100% flat fee provider vs. asset-based fee provider. This can potentially save you significant money going forward. Also, both plans have to be tested together, so someone would have to do that (and it would cost extra). It is always a better idea to have both plans administered by a single provider to eliminate any issues with communication and coordination.
I’ve spoken w/ cashbalanceactuaries.com as a possible actuary. Their fees are presented at their site.
BenefitGuard would manage the 401(k)/PS investments.
Still need to find a financial manager for the CB side.
Do you know of any 100% flat fee provider that can administer both the 401(k)/PS and the Cash Balance Plans?
GMO: I just read through the comments on this CBP article today. My guess is you already moved your plans to new providers. I hope the transition went well.
I would love some advice on strategy in utilizing a cash balance plan. Say my situation entails income of $500k, profit sharing 401k is maxed at $53k, backdoor Roths for me and spouse maxed, and potentially 20-25 years left till retirement, what amount might you place in the plan? Would you keep it low now and increase it later, investing it in taxable accounts and leaving more room in the plan for greater amounts later in the career? Or do you max out the plan contribution now as WCI does?
Remember that the money grows not only tax-protected, but usually asset protected. Seems silly to “save” that kind of space for later. Especially when you may just roll it all into a 401(k) and start over.
If you max out your CB allocation, this plan will only last about 10 years, so yes, you should absolutely use this ASAP, unless you know exactly when you want to retire. The problem is that many groups might not run a CB plan forever because they get bought, merge, etc., so you should absolutely use this opportunity to build up your CB savings. Also, you can have more than one CB plan if one is offered by unrelated employers, so if you work for another practice later that has a CB plan, you can put more money away. The only thing to worry about is how this money is managed and what the cost is to you. Ideally for a plan like this the money should be invested conservatively into low cost index funds and no AUM fees should be taken out of your account.
I stumbled on this site from a google search. Someone asked me if the lower returns of a Cash Balance plan capped at 5-6% are worth putting money into instead of paying the taxes now and investing the money in an after tax account which in theory could garner 8-10%. Have you made a calculation to see which scenario is better assuming no change in tax rates?
You could calculate it, but there’s a lot of benefits you might not be considering:
1) Typically money doesn’t stay in a cash balance plan very long before it is rolled into a 401(k) or IRA. In essence, a CB/DB plan is a 401(k) masquerading as a pension for most docs. We closed ours after 10 years and opened another one. Guess where all that money went?
2) CB plans get asset protection in most states, taxable accounts don’t.
3) Don’t forget the benefit of that asset protection, tax protected growth, and easier estate planning for the next 30-100 years (if stretched.)
4) If your tax rate arbitrage is HUUUGE, then skipping out on a tax-deferred contribution is a big loss. For example, I get a 46% break on anything I put in a cash balance plan, but some of that money could come out at 0%, 10%, and 15% years from now. That makes up for a lot of lower returns.
Also, I’m not sure you understand how most cash balance plans for physicians work. Sure, it might be capped at 5-6%, but if the investments earn more than that, guess who gets that money? The owner, which is usually the physician. Just like you have to backstop the plan if returns are bad, so you benefit if the plan does better. In reality, it’s just another IRA.
You can adjust your 401k plan allocation (and/or after-tax allocation) for the 10 years that your plan is active, and presumably when you start a CB plan, you already have a decent size 401k balance. Your personal account will close in about 10 years if you max the plan out. And as I mentioned above, you can also have more than one CB from different employers, so it is a really easy choice, even if you are ‘only’ getting 3%-5% return in this type of plan.
In theory you can also lose money, so if your CB is aggressively invested and you end up losing money, you will have to eat up the loss and sell your investments anyway to move them back into the 401k plan. For a 10 window horizon, there is no way to guarantee any type of return, even 5%, if the investments in a CB plan are overly aggressive, so I would recommend using CB as your bond allocation for that time period (which may or may not return 5% over 10 years), and concentrating on the tax shelter side of the equation, which is significant enough reason to use these types of plans.
My biggest concerns are the cost of investments and investment management as well as record-keeping and administration for CB plans and excessive portfolio risk. I’ve seen plans with huge AUM fees and very low quality investment management (way too aggressive for the type of plans that these are). The problem with having high volatility portfolios in CB plans is that if the plan has to close (because the group is bought or merges or disbands), the losses have to be made up by the partners. And of course, any AUM fees will subtract from an already low return from the portfolio, so I always recommend using low cost index funds and fixed-fee providers without any AUM fees.
Even if you have multiple cash balance plans, the limit is still 2.5 million benefit correct ?
If you have multiple plans for an entity you own, then the limit is indeed around $2.6M. However if you work for multiple non-related entities, you can have as many CB plans as you can have 401k plans, there is no limit on that. So if you work for multiple group practices each with a CB plan, in theory you can max out multiple CB plans, at least that’s what my understanding is. I believe that lifetime limit is per employer/plan, not for all possible CB plans you might have.
I think the limit is per employer. Plus, if you roll one into a 401(k), it no longer counts. Correct me if I’m wrong Kon.
@WCI: Thanks for the reply. I agree with 1-4. Regarding the return on investment. Hypothetically, if your CBP were to achieve 8% annualized returns, I don’t believe that the additional 2% above the IRS limit goes to the individual but to the company. I could be wrong here but that was how it was explained to us. In any event, I’m asking the question since new employees about to make shareholder/partner are asking me the question and after explaining my understanding to them, they don’t believe it and still feel that the lower rate of return in a CBP for years loses out in the long run to an aftermarket account that could generate a significantly higher return. I personally disagree with them but I’ve been wrong before.
@Kon: Any suggestions on finding a flat fee manager for the CBP? We have a TPA that oversees both our 401k and CBP. We have a financial advisor charging us .25% to manage the CBP and provide oversight on the 401k and education.
The money is indeed allocated to your account pro rata. While it would be great if you can get a guaranteed 8% return, what happens is that you can then contribute less into the CB plan, but because extra return is $ for $ while tax deduction is at most about .05c on the $, it is preferable of course to have higher return. But if your return is lower because of a big loss, then you have to make a larger contribution to the plan, which is not really a good option.
There is no place for ANY AUM advisory fees in a CB plan given how low the return would be. I would be happy to put together a quote for your plan, since I specialize in working with combo plans and especially CB plans. I’m an ERISA 3(38) fiduciary, and that’s the least you need to manage a CB plan because anyone else won’t have full responsibility (and corresponding liability) for making plan level decisions on plan sponsor’s behalf.
I disagree that having to contribute more to a plan is necessarily bad, assuming you are the business owner too. Basically, it forces you to buy low (i.e. contribute more while the market is down). That’s not necessarily a bad thing.
If you’re an employee, then yes, you’re right. The extra reduces the company’s future pension related expenses and doesn’t go to you. If you’re the company, then you’re wrong. It’s all the same money. With regards to my plan, I’m the company backstopping the defined benefit plan. If returns are poopy, I have to contribute more money. If returns are great, I can contribute less or get to keep the extra in the “side account” when the plan closes.
You know Kon’s profession is exactly that, right?
“In any event, I’m asking the question since new employees about to make shareholder/partner are asking me the question and after explaining my understanding to them, they don’t believe it and still feel that the lower rate of return in a CBP for years loses out in the long run to an aftermarket account that could generate a significantly higher return.”
This is exactly where I am, my fellow younger partners, several of whom have MBA degrees and all of whom seem much more financially savvy than myself, agree that the after tax account is the way to go at our stage of the game, but WCI and others on this forum are stuffing the max into CB plans… so is there a correct answer? Or is it sixes?
Really appreciate the input.
Like most stuff, the right answer is “It depends.”
Factors favoring the DB/CB plan:
1) Desire for asset protection (now and for decades afterward)
2) Desire for less aggressive asset allocation
3) Likelihood of closing the plan soon to lower expenses and roll the money into a 401(k)
4) Being the business owner
5) Low expenses in the plan and its funds
6) Big difference between marginal tax rate at contribution and effective withdrawal tax rate
As a “no-brainer” example, if you have a DB/CB plan that you’re only going to use for 2 years before it is closed/rolled over and you’re in your peak earnings years, use it. On the other side, if you have a DB/CB Plan with really high expenses, you’re not the owner, neither you nor the plan is going anywhere for decades, you don’t care about asset protection, and you expect to have huge RMDs and rental income in retirement, well, I could come up with a scenario where taxable investing makes sense.
This is a great question, but the MBAs have gotten it all wrong. Getting a tax deduction with a lower return (and then rolling the money into a 401k plan) is a lot better than after-tax. I don’t know what type of analysis they’ve done, but a Cash Balance plan (that typically only lasts 10 years at maximum contribution) is but an extension of your overall portfolio, so one should look at the entire portfolio over the long term, and consider the tax benefits in that context.
So if you start with a 401k plan, you might have a significant portfolio already invested in a 401k. Over the 10 years when you are maximizing your 401k, you can simply allocate more of your 401k to stocks while using your CB portfolio as your bond allocation. After 10 years you have no more CB contributions, so if you are retiring or closing a CB plan, that money can be rolled over into a 401k plan, and if not, then there are no more contributions coming into that account, and it can simply be used as your fixed income allocation.
With a Cash Balance plan it is the tax differential that makes all of the difference. You can get yours to be as high as 20%-30% depending on where you retire and what your income is in retirement. There is no question that adding a CB plan (which provides additional tax deferred space) will be a good idea for most medical/dental practices, and it makes the most sense for those who are 10-15 years to retirement.
If you are relatively young, you might wait to make contributions into a CB plan, and it is always a good idea to invest after-tax anyway, on top of any tax-deferred contributions.
OBEX: I just read through the comments today, so I’m late to the party. Have you had an Actuary/TPA run the numbers on a combo CBP and 401k Plan? If not, this would at least show you the contributions that are possible for the owners based on their income and ages and how much the owners would have to contribute to your employees in order to pass nondiscrimination testing.
WCI,
Have you opened a new CB plan? What are the new management fees? Is it still with MedAmerica? Were you charged a fee to close the old plan and to roll it over into 401k?
Thanks!
We closed the one we had and opened another one. Same management fees. Yes, there was a fee to close and re-open. Yes, still MedAmerica.
JB: I don’t know if you’re still thinking about implementing a CBP, but let me know if I can answer any questions. I help business owners design CBP and then provide ongoing TPA services for the plan. Note I do not help you invest the plan assets. I just tell you how much you can contribute on a tax deductible basis. You would work with your Financial Advisor to figure out how you want the assets invested.
Hey WCI, are there any other companies besides MedAmerica that offer cash balance plans that you know of?
It seems difficult to navigate MedAmerica’s website. I just see one email/phone on the website; is that their main point of contact?
Do you mind clarifying what type of fees you have? The best I can see from the website is “Fees for small group (under 50 physicians) 401k plans are fixed at .40% of plan assets annually. In addition, there is a $6 charge per enrolled physician per month. These fees will be paid directly from plan assets. For defined benefit plans, fees are fixed at .60% of plan assets.”
Thanks.
We set up and manage low cost 401k and Cash Balance plans for medical practices. We can certainly do it at a fraction of the cost MedAmerica is charging, and we provide better quality services as well. I just submitted an article to WCI on Cash Balance plans that should be published in a couple of months, and this should also have a lot of good information for group practices.
Here’s how we are different:
1) You get your own actuary/TPA that will optimize your plan design, so you will have every partner deciding how much they want to put away (rather than be limited by a set contribution schedule).
2) You also get your own ERISA 3(38) fiduciary who will take full responsibility for managing of your CB/401k plan portfolio.
3) Only low cost index funds (Vanguard/DFA) are used for both 401k/CB plans. Average expense ratio for portfolios is 0.1% for CB plans and 0.15% for 401k plans.
4) No asset-based fees charged by providers. Record-keeper has a small custodial fee that can be paid directly rather than taken out of plan assets (5 bps), and this is a fee that all record-keepers charge that I couldn’t negotiate down (Matrix is the custodian).
More information can be found here:
https://litovskymanagement.com/services/
Why are your 401(k) ERs higher? Why not use the same funds in both? Target Retirement funds?
Wouldn’t it be wiser to pay the record keeper fee from plan assets since it could then be paid with pre-tax dollars?
Because paying money from your assets directly decreases your compounded return vs paying it outside of the plan. And you get a business tax deduction on top of that.
I just submitted a 4000 word article to Jill on CB plans for group practices, everything should be explained there, including how the portfolio for the CB plan is selected. Definitely no TDFs in CB plans, I actually never saw this even with other companies. If anything, a custom-built portfolio if this is a plan that is run in perpetuity, and definitely very low volatility for smaller plans that are under risk of imminent closure (so ER is much lower because the investments are mostly bonds).
Most CB plans for group practices are mismanaged because they are treated as a DB plan that is run in perpetuity, while in reality there are huge risks to such plans so these risks should be taken into account when building a portfolio.
I’ll have a talk with you guys to see if it’s a good fit. I am a one-person S-corp looking for extra tax sheltering.
Are CB and 401k plans typically fused together? I already have a separate solo-401k set up for myself that I manage on my own in terms of asset allocation. For your services it a requirement to have both 401k and CB plans serviced by you?
XILEX: As a one-person S-Corp, you are an ideal candidate for a CBP. It’s not a problem that you have a separate 401k Plan already. Depending on how much you want to contribute to the two plans, adding a CBP might reduce your profit sharing contribution limit from 25% of your w-2 from the S-Corp to 6% of your w-2.
Here is a link to CBP FAQs: http://www.luriellp.com/wp-content/uploads/2015/08/MyCPB-Final.pdf
I’m sure there are lots of other companies out there. LMGTFY…..here’s one:
https://www.dedicated-db.com/occupations/defined-benefit-plans-physicians-dentists/
Schwab has a “personal defind benefit plan” for independent contractors as well.
MedAmerica isn’t one of my partners or advertisers or recommendations or anything. They administered the 401(k) and the DBP for my partnership when I joined. I email Chris Renner when I have a question. rennerc (at) medamerica.com.
My group is larger than 40 physicians so I think we pay a less than the 0.60% and 0.40% for the 401(k). I don’t know if I’m allowed to disclose exactly what we’re paying. The fee is higher than the fee to run the 401(k). I suspect there are less expensive 401(k)s out there and probably DBPs. After you’re done with your search, why not write up your experience and submit it as a guest post?
I’m familiar with both Schwab and dedicatedDB, and while dedicatedDB specializes in tiny plans, and their fees are on par with what my actuary charges, however they don’t manage plan investments or act in a fiduciary capacity. Schwab also works with smaller plans, and while their fees are low, they don’t provide any service for those who have no idea what’s going on, so again you get what you pay for. While we do work with solo plans, our fees are a lot more competitive for practices with staff and for larger plans (such as group practices) that need full service approach for a competitive fixed fee.
> After you’re done with your search, why not write up your experience and submit it as a guest post?
😀 maybe I will!
Sounds like I’ll have to do some independent research on this to get actual numbers for fees. I neglected to say that I’m looking for a plan for a one-person S-corp setting. Both you and sidehhustlescrubs have group plans, so that’s probably going to be different.
I think Schwab charges $1250 a year for a solo plan. Don’t quote me on that though.
It is a 1500 setup, and 1500 annual fee per their website. If I’m putting a sufficient amount in each year, it should technically offset the potential tax savings. I’ll be talking to them in the future to see if it makes sense to open a plan and if they are a good fit in terms of fees and such.
Yes, obviously at those prices it doesn’t make sense for a $10K annual contribution.
Yes, this is not a plan for casual contributions. For solo, I prefer a solid $150k total contribution before it makes sense. So this is at least 40 years old.
I’m about 33 y/o, still able to live on fellowship -level salary, so there is a lot of income left to work with. I’m also probably going to cut down to half time after I’m in late 40s. I guess there’s not much I can really do then, realistically, in terms of tax-sheltering, outside of 401k + backdoor Roth? I am aware of HSA and 529, also.
No, just no. Max out your 401k plan, max out your HSA/Roth, and don’t forget after-tax. This is a huge bucket, should be at least as big as tax-deferred. Pay down all debt, and you’ll be fine. CB plan is really for 40+ crowd, with notable exceptions (group practices with docs of different ages). So if you partner with someone, the value of a CB plan will increase as costs will be split evenly among partners regardless of their contribution amount.
What do you mean by after-tax? Currently my 401k is pretax, the backdoor Roth is post-tax, health insurance is not set up to quality for HSA.
After-tax meaning an investment account at a discount broker. Not a retirement plan.
Xilex, as another option, my firm (luriellp.com) provides actuarial services for and administers combo 401(k) Plans and Cash Balance Plans. Listed below is another opportunity for you not discussed in this string.
Let’s assume that you only put a solo 401(k) Plan in place for yourself and that you are a single member LLC taxed as an S-Corp. Note this same idea would work if you’re a sole proprietor, but working with a w2 gets us around the circular calculations involved with self-employment income. Let’s also assume the LLC makes $200k in revenue and of that $200k, you pay yourself a w2 of $100k. How much can you contribute to your solo 401(k) for the year?
You can make $18,500 in deferrals and $25,000 (=25% of $100k w2) in profit sharing contributions for a total of $43,500 in tax deferred contributions to your solo 401(k) Plan for 2018.
The DC limit however is $55,000 for 2018. Is there a way for you to contribute the difference of $11,500 (=$55,000 – $43,500) more to your 401(k) Plan for 2018?
Enter “voluntary after-tax employee contributions.” Provided your plan allows them, these voluntary after-tax employee contributions go in on an after-tax basis and then you do an in-Plan Roth conversion on these after-tax contributions. I call this the super-sized back door Roth. If you wanted, you can skip the pre-tax all together and just make all of your contributions on an after-tax basis and create a big bucket of Roth dollars in your 401(k) for yourself.
You are likely going to have to work with a firm like mine to make voluntary after-tax employee contributions. The big online brokerage firms (Fidelity, TD Ameritrade, Vanguard, etc.) offer free solo 401(k) Plans which work for most. These large solo 401(k) plan providers offer no bells and whistles and so you can’t make voluntary after-tax employee contributions, nor can you do in-Plan Roth conversions.
This makes a big difference. I If you want to DIY, schwab is definitely the cheapest but also the worst in terms of service you get. You’ll have to do all of the research yourself and manage your portfolio yourself as well. DedicatedDB is a notch up from Schwab in terms of actuarial services. For their prices you can actually hire your own actuary/TPA to administer both plans.
Both plans are managed together by a single plan admin, so you can’t have a separate 401k plan – it is basically part of the ‘combo’ plan because of the way contributions are calculated. I typically manage both of them because of my approach to asset allocation – CB plan contains mostly bonds, and 401k plan contains mostly stocks, so I typically manage both plans as a single asset allocation, which makes it much easier to manage.
Also, because combo plans fall under ‘personal financial planning’ engagement (that is, it is a non-ERISA plan), I also provide tax planning and investment advice on the entire financial situation, not just on the combo plan, and typically I will put together an asset allocation for all accounts, though only the combo plan will be under my direct management.
I also typically use a record-keeper for the combo plans, not just a custodian, and that’s because I don’t like the lack of service that custodians such as Vanguard provide. So this adds a little in cost, but I believe it is more than worth it.
> Both plans are managed together by a single plan admin, so you can’t have a separate 401k plan – it is basically part of the ‘combo’ plan because of the way contributions are calculated. I typically manage both of them because of my approach to asset allocation – CB plan contains mostly bonds, and 401k plan contains mostly stocks, so I typically manage both plans as a single asset allocation, which makes it much easier to manage.
Is this an IRS/legal requirement (401k/CB under single admin), or something that you require?
So if I’m putting 55000 into the 401k and 50000 in CB, hopefully you’re not putting my in a 50/50 stock/bonds split, right? 🙂
Not a legal requirement but if you have two plans, it is not only cost effective but a good idea to have a single plan administrator that takes care of both plans. Someone has to file form 5500 for both plans as well, so it is much easier to have a single admin do it.
If you are only putting away $50k into a CB plan, that might be a little premature for you to start one. By the way, you can’t put away $55k into a 401k plan since you’ll be limited to 6% profit sharing, and more money will go into your CB plan to compensate for that. Ideally you’d want to put away at least $150k or so into both plans. Asset allocation depends on multiple factors, solo plans have a lot more flexibility as far as asset allocation.
I see. With a solo-401k it sounds like I would only need to fill it once assets exceed 250,000. It shouldn’t be too hard to figure it out (5500-EZ).
> By the way, you can’t put away $55k into a 401k plan since you’ll be limited to 6% profit sharing
Where are you getting this limit from? I thought it is 25% of employee’s gross income, at least with a solo-401k.
For a combo plan the requirement is different:
“If you have more than 25 active participants your Cash Balance plan will be covered by the Pension Benefit Guarantee Corporation (PBGC), so you are not limited in your profit sharing contribution to the 401k plan. However, if your plan is not covered by PBGC, the profit sharing contribution is limited to 6%, except when total employer contributions (401k plus Cash Balance) do not exceed 31% of payroll. So in some cases, you can contribute more than 6% of profit sharing even if you have 25 or fewer participants.”
So if you want to things yourself, you might want to read up on all of this stuff, otherwise you might end up making mistakes that will require someone to fix them later on. You might save a little by doing everything yourself, but I don’t recommend going that route with a combo plan. At the very least, getting a good TPA/actuary is a must for combo plans, and I would let them do all of the filing of the forms.
Thank you for the replies. This seems to have gotten more complex than anticipated. Do companies like yours run numbers for clients to see if it would make sense to have such a plan (401k + cash balance plan)?
Absolutely. As a fiduciary, I don’t randomly open plans for people. The fit has to be perfect before we proceed with setting up a plan. So as you can see if you are young, it turns out that you might be better off just maxing out your 401k for a while until you can put away more into a CB plan (which is usually age 40 or older). Your max CB total lifetime contribution will be significantly lower if you are younger vs. older. I’m also looking for a net of at least $400k that’s consistent and very little debt. The threshold is much higher to set up a combo plan, that’s for sure.
If you close the plan and roll it into a 401(k) or IRA, do you get to restart your lifetime total?
Not if the plan is for the same entity. I have to check about starting two businesses by the same owner. If you are the employer (100% owner), it might not matter that you open separate businesses, your limit might be the same regardless. However if you work for multiple group practices – you can have different plans with different limits.
There is definitely room for abuse if a single owner simply ‘closes’ a business and opens a new one that is substantially similar to the original one for the sole purpose of stuffing a CB plan. So this would depend on the circumstances, I’m sure the actuary knows exactly how to determine whether you can have two limits vs. just one.
If you are a sole proprietor simply changing the source of 1099, that’s not going to work. But if you change a group practice, even though you are doing the same job, you are not the employer, the practice is.
>I see. With a solo-401k it sounds like I would only need to fill it once assets exceed 250,000. It shouldn’t be too hard to figure it out (5500-EZ).
You are correct that once the 401(k) plan assets exceed $250,000, you are required to file a Form 5500-EZ for the plan. Note that if you have a solo 401(k) Plan AND a solo Cash Balance Plan, you add the assets from both plans together to see if the assets exceed $250,000.
For example, if your 401(k) Plan assets are $100,000 and your Cash Balance Plan assets are $175,000, a Form 5500-EZ is needed for BOTH plans even though the individual plan assets are less than $250,000.
Once a year. But yes, it’s an easy form. https://www.whitecoatinvestor.com/irs-form-5500-ez/
I was wondering if you could clarify how deficits are funded for the CBP when there are downturns in the yearly performance of the investment portfolio. Let’s say the portfolio was worth $100K at the start of the investment period.
The yearly return was guaranteed to be 3%. For that year the return was only 1%.
(I am assuming that return is total return—i.e. the change in the value of the individual securities and also the investment income they spin off?)
So, under ideal circumstances the ending balance after one year for the portfolio should have been $103,000 but is now only $101,000. Assuming that there is no reserve fund to make up the $2000 deficit for that year, is each partner assessed an equal portion of the $2000 deficit or is each partner’s share based on the percentage of initial capital that they contributed? For example, if I had contributed half, or $50,000, to the portfolio from the start with all the other partners contributing less would I be assessed 50% of the $2000 deficit to make up?
Finally, if a partner should leave the plan during a downturn in the portfolio, that partner is entitled to get back the total amount they had invested over the years plus the defined yearly interest rate for that period of time. So where does that leave the partners who are staying behind and who have to make up any deficits for the departing partner? This was a big concern in our group who is looking at setting up a CBP. What ways are there to minimize the impact on the partners who will still be in the plan?
Thanks.
The owners have to fund the deficits. No big deal if the owners are the only participants. In which case it is done proportionally I would expect in most plans like the situation you describe.
Closing the plan every few years and encouraging retirees to roll their money to an IRA helps mitigate that risk.
This is a good question, and this is what the actuary says in response:
“This will usually be defined in the shareholder or partnership agreement as different companies do it differently and there is no legal requirement for how to treat actuarial gains or losses. Most companies require that deficits be made up in the following year and that no owners are paid out of the plan until the deficit has been made up. And the amount of the make-up contribution due is usually based on the balance in the plan.
So in the example provided, the doctor would contribute $1,000 for his or her share since he or she had $50k of the $100k total at the beginning of the year. It’s one of the important reasons to use beginning of year actuarial valuations for a multiple doctor plan like that. So if the loss gets big enough, there is still time for the doctor to amend his contribution formula for the following year as necessary.
Let’s say for example all of the assumptions are the same, except that it’s the 15th year of the plan and the doctor has $1 million out of a $2 million plan. Assuming the same 2% shortfall, this is now worth $20k. So he could contribute $70k to make up for the loss. But if he or she can’t afford the extra $20k, a plan amendment could be done to lower his or her allocation for the following year to $30k. That way, the out of pocket for the doctor is still $50k. It’s just that $20k is going to make up for investment shortfall and only $30k is going to increase benefits.
Partners who leave during a shortfall period are usually required to make up their portion of the shortfall as part of the final payout. Depending on the rules for the particular partnership and the amount of the shortfall, this is either funded out of the final paycheck, any receivables, or any equity buyback. Conservative investments can help limit the risk.
Lastly, if the CBP covers only the doctors, an actual rate of return plan with a 5% cap on return could be considered. These are only right for a very specific plan design situation because of the effect on the required employee contribution to pass nondiscrimination testing, but it can basically eliminate the investment risk if your demographics are right. ”
So I would not recommend terminating a CB plan unless the practice is merging with another one, or the practice is closing. There are very few reasons to terminate a plan and restart it again. If the investments are managed prudently, and the plan is designed and administered correctly, there is very little risk to individual partners.
What about the value of “supercharging” an IRA with DB plan contributions over a period of 7 or so years?
What in your opinion constitutes a reason to close a plan and reopen it?
How long between the old plan and new plan would you recommend waiting? Can you do it within the same calendar year?
It is really not my opinion, but that of IRS and actuaries working on CB plans. There are a number of valid reasons such as substantial change in plan design, business changes, etc., and you can potentially close the old plan and reopen a new one, but this would be a one time thing if nothing really changes or if there are no valid reasons going forward. The actuaries have to advise the plan sponsor on what’s possible and what is a stretch. Some are more aggressive than others because there isn’t a lot of case law to lean on, so you have to be careful. But usually a redesign of the plan is one valid reason. You probably won’t be able to do it more than once though. You can open another plan right away, that’s not an issue (for the following calendar year, not for the same one).
Respect your input and was looking to see if you had any guidance. Graduated residency and I’ve been doing locums work until I commission with the Air Force in June. I was sold a whole life policy after graduation as a retirement vehicle with the idea that it’d be an addition to the tax advantaged accounts I already maxed out since I have no debt to pay off. From everything I’ve read here and on bogleheads, I’ve been swindled. So I started reading on your site about how to go about closing the whole life plan….but I haven’t been able to completely convince myself that the whole life plan is all that bad — it will offer tax-free distributions in retirement to help keep my tax bracket low, and it offers a low but guaranteed return. I recognize it doesn’t have the same tax advantages as a cash balance plan, but for someone who doesn’t make enough to justify opening a cash balance plan and will be in the military for the foreseeable future (where after tax contributions may be more valuable), would it really be such a bad idea to keep the whole life insurance as long as I’ve contributed maximally to all other plans/options (individual 401k for locums, backdoor roth, TSP after commissioning, taxable ETFs/stocks)? I understand if I invested the money I’d put into the whole life policy in the market, that the money would almost certainly outperform the whole life policy — but couldn’t it be a reasonable idea (for the sake of diversity) to keep the policy for the benefits of tax-free distributions in retirement as well as the protection against any catastrophes in the market or potentially retiring in a down market when my qualified plan distributions may not be as valuable? I imagine you’re sick of answering whole life questions, but I’d most appreciate any advice you can spare.
No, it won’t be a good idea, but depending on how much money you got in it, it might be quite expensive to terminate it. You have to fund this policy at a certain level, and hopefully you get rid of it way before retirement. You are basically ‘borrowing’ your own money, and you also will pay as much as 8% to the company to do so. I find nothing good about that.
If you want decent (low and relatively safe) tax-free return, you got municipal bonds to consider. If you want more yield, you can buy individual municipal bonds, and these are guaranteed by the state (if you buy GO bonds), so probably safer than Whole Life. A diversified portfolio after-tax (with muni bonds instead of taxable bonds) can also do the trick. I can’t add anything else to what WCI wrote on this topic, so the only consideration I would have is when to get rid of it. If it was me, I’d probably take the loss and start investing properly, as I wouldn’t want to throw good money after the bad.
Thanks for taking the time to answer
Do what you like, it’s your money. Your choices, your consequences.
Personally, I find a 2% guaranteed return for something I’ve got to hold for 50 years to be pretty pathetic. Even the 5% projected return isn’t so hot. And that’s good policies. I’d much rather invest my money in stocks, bonds, and real estate and pay any taxes due than use a life insurance policy with lower after-tax returns. Don’t let the tax tail wag the investment dog. You don’t seem to have any need/desire for a life long insurance death benefit, yet that’s what you bought. You can’t max out a taxable account. There is no limit.
https://www.whitecoatinvestor.com/retirement-accounts/the-taxable-investment-account-2/
By the way, there are no “tax-free withdrawals.” It isn’t a Roth IRA.
https://www.whitecoatinvestor.com/8-reasons-whole-life-insurance-is-not-like-a-roth-ira/
You can take out your basis as a partial surrender (basis is always tax-free) and you can borrow against it like your house (loans are always tax-free but not interest free.) I don’t find it to be an attractive asset class, so no, I don’t buy the diversification argument. I mean, you can diversify into cryptocurrency or pork bellies or beanie babies. Why choose whole life over those alternatives?
https://www.whitecoatinvestor.com/debunking-the-myths-of-whole-life-insurance/
Good luck with your decision of whether to keep it or ditch it.
https://www.whitecoatinvestor.com/what-you-need-to-know-about-whole-life-insurance/
I’m currently evaluating whether it makes sense for me to contribute to the CBP being offered by my large, multi-state physician group in addition to our 401K/PS plan. My wife and I are both young physicians (early 30s) with expected combined yearly earnings of $1M+ for the foreseeable future.
Obviously, any additional tax-protected space investing is welcome. However, my main concern is that the plan indicates that it aims for its crediting rate to track the 10-yr T-bond. Your points regarding the additional asset protection and potential for rolling the plan into a 401K are well-taken, but I am concerned regarding this very conservative crediting rate and whether or not I would be better off investing in taxable instead. Based on my conversation with the plan administrators so far, there isn’t any plan to terminate the plan at a pre-determined date.
Any additional insights or suggested questions to ask my employer or the plan administrator (Sentinel Benefits) would be appreciated. Thanks!
Why not invest the rest of your portfolio a little more aggressively to make up for it?
Great question. The way the CBP is currently structured, the initial contribution requirement is $90K/year. There’s is no option to contribute any less than that. Obviously, that will need to be adjusted downward over time based on the lifetime maximum contributions and my age.
As we plan to save ~20% of our gross income with a 90/10 stock/bond mix, this would initially skew our portfolio more toward bonds than I would like. Also, due to the non-discrimination testing requirements, participating in the CBP will decrease the amount that I can put into my 401k/PS plan by around $23.5K. I’m trying to determine if this is money I would be leaving on the table if I chose to do the CBP, or if I would ultimately receive it as direct compensation.
I’d really love to take advantage of this additional tax-protected space if it seems reasonable in spite of the above and the conservative crediting rate target.
Again, a ‘defective’ CB plan. Why can’t you contribute a specific amount? I call this lazy design. Each doc should be able to specify their contribution amount so that you can start small and increase it later on if you’d like. It is usually more difficult to contribute higher amounts vs. lower amounts to pass discrimination testing. I can’t comment on the details of your plan’s design, but I would have it reviewed by an actuary to make sure it fits the needs of the group because you should be able to specify your contribution amount to be anything you’d like.
All that said, if your net is $1M, then it is a no-brainer to put away $90k into a CB plan (or the most possible). You can easily balance this out with taxable investments. If you can also max out your 401k plan at $57k, that’s the best deal you can get vs. leaving money after-tax.
Exactly. I’ve done the math and taxable for highest brackets is not going to beat tax-deferred even with a relatively low rate of return. Intermediate treasuries can potentially return around 3%-5% depending on the market. Treat your CB allocation as your fixed income, and go more conservative in your 401k and after-tax/Roth, etc. Presumably your CB contribution isn’t going to be very high anyway, so you would expect your 401k + PS to outgrow it, ideally, even if the amount contributed is the same into both plans.
My group DBP [ total of 6 physicians] has reached maximum funding level 3-4 years ago.
1-We are exploring ways to terminate the plan, and roll the ownership interest in the plan to our respective indivual 401Ks,
Any thoughts, anyone has experience going through this?
2-Regarding ownership interest, we kept a side agreement of who owns what in the DBP, ownership interest ranges from 7-20%, depending on contribution level. Anyone sees any legal ramification with side agreement?.
3-If we successfully terminate the group DBP, can each one of us start his/her own DBP? we are organized as an LLC [K-1] partners.
1. Yes, I’ve done it twice.
2. Good discussion to have with the pro helping with the account. DBPs aren’t really a DIY project. What’s in there that you need an agreement about who owns what?
3. No. It has to be a partnership plan. Whether you can even do another one I don’t know.
Appreciate the response.
Yes, we do have a third party administrator, I just wanted to have enough ammunition when discussing with my partners and third party administrator.
on item #2, there is nothing there but stocks/mutual funds/bonds, the percentage ownership is different.
thank you again
The plans I’ve had don’t track percentages, they just keep track of a dollar total that is yours, just like a 401k.
I am currently in a medical partnership (very large, many many partners) and have the option to contribute $30,000 to a defined benefit plan (DBP). I am actually planning to leave my partnership in the middle of 2021 to relocate and start a new job with a large university healthcare system.
I would like to contribute $30,000 to the defined benefit plan with the goal of rolling this to an individual 401k that I already have open currently . Is this possible? I have a Schwab individual 401k.
I have never contributed to the defined benefit plan before so would there need to be money in there for a certain amount of time?
Is it typical that one would have to roll the money out of the defined benefit plan immediately upon leaving the partnership?
If Schwab does not allow rollover from DBP -> individual 401k , do you know which individual 401k’s do?
Contributing the money to the DBP would get my married filing jointly income down to the level where I would nearly fully benefit from the pass through deduction and would avoid hefty CA state tax and a significant marginal federal income tax.
Thanks in advance for your help!
It depends on the vesting schedule. If you are fully vested, this will work. Assuming you are fully vested, yes, there is no reason why you can’t contribute and roll it into your 401k right away once you leave the job. There is no reason why this rollover will be disallowed since it is a perfectly legal one, but it is worth checking ahead.
Yes. You should be able to do that once you leave the partnership.
There is no minimum length of time it must be in there.
Typically you do not HAVE to roll it over (I think the DBP has to give you the opportunity to annuitize it if you want, it is a pension after all), but you can and people usually do.
Yes, I think your Schwab i401k accepts rollovers. I know Fidelity does as well. More info here: https://www.whitecoatinvestor.com/where-to-open-your-solo-401k/
There are much more knowledgeable posters that can clarify, but your plan should work. You should check the DB plan documents or discuss with the plan administrator, but typically when you leave your employer then you can roll out your DB benefits into a 401k (individual or traditional), as well as into your IRA (401k would likely be preferable if you are or plan to do back door Roth conversions). Many plans, including ours, essentially requires the terminated employee DB benefits to be rolled out of the plan.
WCI has a post on which brokerages allow rollovers into individual 401ks. I’m not sure about Charles Schwab. Vanguard doesn’t allow it. E-trade is high on his list—that’s who I use (we terminate and restart our CB plan every 5 years and roll everyone’s assets into their 401k or IRA in order to reduce the market risk to the company)
Haha, sorry, I clicked from my email so I didn’t see that your question had already been answered by both a CB professional and the WCI. At least my answers were consistent with theirs! 😅
“we terminate and restart our CB plan every 5 years and roll everyone assets into their 401k or IRA in order to reduce the market risk to the company”
This is exactly what is increasing the risk to the company. First, you can not do this more than once in the lifetime of the plan. Even the most aggressive actuary will tell you that. And you certainly can’t do this every five years and expect the IRS to go along with it. There are several reasons why this strategy is wrong. One of them is that the risk to the company is reduced by properly managing the CB plan portfolio (which is often just mismanaged due to excessive risk taking). There is really no risk to the company if the CB plan is properly understood and taken care of, as all concerns are addressed with the properly designed portfolio and a strategy for taking care of both under- and over-funding. With that out of the way, CB plans can be maintained for quite a while, though for most practices that would be 10 years until most partners have maxed it out. You can certainly stop/terminate the plan once, but definitely not every 5 years.
I don’t know, effectively that’s what we’ve done. I’m on my third one in a decade. The company changes forms like most do and there seems to be an IRS approved reason that lets us terminate it so we do.
Yes, IRS approved reason would work. But there has to be a very good one. And if IRS does not approve, the results can be rather bad, so if anything, excessive termination and restarting increases the risk. I can’t imagine doing 3 terminations in 10 years, that seems quite excessive. So for each such reason I would seek an ERISA attorney’s letter of opinion before doing anything of this sort because there isn’t a lot of guidance, thus any plan might be singled out for audit and penalties if IRS decides this is an abuse. A lot of times partners are the ones deciding they want to do this and actuary might simply go along to get along. Thus my argument that doing so increases the risk despite what some experts may say. Unless the expert also put their opinion letter in writing, their opinion is not worth much under the circumstances.
Physician groups are merging, being bought out etc so frequently that the chances of a CB plan actually making it ten years without having to be stopped seems pretty low to me actually.
I suppose there is always a risk of the IRS saying your reason wasn’t a good one, but they can’t force you to keep a CBP forever.
Yes, but that’s not what we are talking about here. Of course, if the employer is different, the plan is different if the employer is no longer in existence, that’s by definition. And of course, most plans will be around for about 10 years, so they’ll have a single restart somewhere along the way, and that’s it. We are not talking about these scenarios, they are all taken care of under the normal operation of a CB plan.
Some groups will have a plan for a very long time given the turnover and their size. We are talking about simply terminating and restarting on a schedule (every 5 years) without any justification other than to supposedly lower the risk to the partners. This is very subjective because with a low volatility portfolio you don’t have much risk, so if that’s justification, there is no risk because this is not a DB plan that is risky due to the fact that it has to exist for many decades. A CB plan can be terminated very quickly and all assets are distributed, so the risk is not there.
Another argument is that high account balances lead to potentially very high contributions if the investments are under-performing the crediting rate for example. That’s true, and it becomes an issue once you hit $2M-$3M range and your portfolio is volatile. So you can have one restart after enough partners reach this level after 7-8 years maybe. This will take care of most of the risk due to this issue.
What is happening here is that partners want to get a hold of this money to invest on their own, so they are making the actuaries implement this type of strategy for them. If the portfolio is too high risk – decrease the risk, hire an ERISA 3(38) to manage the risk of your portfolio appropriately. Why close and restart the plan? I don’t think this reason will work with the IRS unless there is an ERISA attorney willing to sign their name under this strategy (which so far I’ve not seen a single case of this).
My group is on cash balance plan 2.0 after starting our initial plan. We work with an independent ERISA attorney and independent actuarial firm. When we terminated plan 1.0 after ~5 years our attorney submitted a request to the IRS for a “Determination Letter”. This letter is essentially the IRS stating that the reasons submitted for terminating the plan are valid. The IRS may (and did in our case) request some additional information prior to issuing the letter. Once we received our Determination Letter we proceeded with terminating the plan. The entire process was coordinated & directed by our attorney. Given experienced and qualified plan advisors our group felt there was minimal risk in terminating our plan and moving on to plan 2.0.
Yes, absolutely, this is allowed if you have substantial changes to your plan design that can be documented and that are valid in the eyes of IRS. Any CB plan can do this once in the lifetime of the plan. The issue becomes if the group wants to run the plan for longer than 10 years, and they want to restart the plan every 5 years just to get their investments into a 401k plan. This strategy is definitely not approved by the IRS and can cause issues.
And of course, some groups simply want to do this because they want to move their money into the 401k plan after 5 years. This is would not be a valid reason for termination and restart.
With all due respect and recognizing this is your professional expertise, we have received guidance from several experts in the field that have not only confirmed, but encouraged us to close out the plan and restart every 5 years or so. We do need to track the total value accumulated in each CB so as not to exceed IRS lifetime limits per individual. I’m not saying you are wrong, I’m just pointing out that other expects have said differently.
Did those experts happen to be ERISA attorneys, and did they write letters of opinion in case of an IRS audit? If not, then it does not matter what they say because if your plan is audited, they will be nowhere to be found. My statement that this increases the risk to your plan is still accurate, so even if experts disagree, given lack of precedents and the fact that these plans are quite new, I would recommend caution and using a good ERISA attorney to justify each such closure and restart (as WCI noted above), and if they recommend the 5 year close and restart strategy, they must have an ERISA justification for it. And at the very least I recommend getting a legal letter that is justifying this strategy. If IRS finds abuse, who knows what they might do – possibly disallow the deduction for the plan? I really don’t care to find out one way or another what would happen if a plan lands on the wrong side of the IRS opinion. Theirs is the only one that counts. I’d be more than curious to see how this strategy is justified and who recommends it, because I work with several well known actuaries, and they are not recommending it this way at all. And when you have such stark disagreement on strategy (vs. just a disagreement on the tactics), there has to be something wrong with the strategy. Of course, nothing might happen, and you might end up fine. But this is exactly the same thing with questionable tax strategies of which there are many. Everything is fine until you get caught. And then all bets are off. I will stick to the low risk ‘boring’ strategy of using CB plans the way they are intended to be used – as a tax shelter that runs for about 10 years, and possibly longer. We might recommend a single restart of the plan after maybe 7-8 years, but that’s about it, until such time when the above-mentioned close and restart strategies are explicitly approved by the IRS.
my 2cents.
The DBP for our group[ total 6 docs] is undergoing an IRS audit now. We had the plan for 11 years, stopped contributing 3 years ago because we reached the maximum contribution limits per acturial accounting. Though we think we dotted all the i’s and crossed all the t’s, we are sweating bullets!.
I
Unless I’m missing something, it sounds like your plan was front loaded and you put in more but had to keep it open just to use up the contributions, since you couldn’t terminate it after 8 years when you maxed it out. Probably not the best strategy (I would recommend not front loading it this much but rather spread your contributions to get a tax deduction over 10 years, though maybe if you had a few very good years it made sense to do this), but this sounds fine, seems nothing wrong here.
my 2cents.
The DBP for our group[ total 6 docs] is undergoing an IRS audit now. We had the plan for 11 years, stopped contributing 3 years ago because we reached the maximum contribution limits per acturial accounting. Though we think we dotted all the i’s and crossed all the t’s, we are sweating bullets!.
I
Will Vanguard or Schwab administer cash balance plans? I can only imagine their fees would be less.
Vanguard or Schwab does not administer group practice CB plans. First and foremost, ‘less’ does not really apply to CB plans because they are more expensive than 401k plans to start with. There is a lot of work involved. Also, Vanguard and Schwab are not exactly known as the standards for plan administration quality. While the cost can sometimes be less, the service quality (which also applies to other record-keepers) is of much lower quality than if you hired your own TPA for example. This does add to the cost, but this is a must if you want to have a well run plan, especially for a group. Otherwise someone will have to spend time to do research and to bounce things off of the record-keeper staff, who are not going to advise you on anything since they don’t possess the highest level of knowledge and they don’t offer advice.
Schwab does administer solo CB plans, so that’s one option, but their cost is not much lower than if you hired you own actuary (which would be preferable in all situations given that you don’t get access to your own actuary with Schwab).
My experience with Vanguard and any retirement plans is yes, they are often cheaper, but that also often means they do less and provide less. Cheaper isn’t always better if you can’t get done what you need done. I don’t know anyone with a Vanguard cash balance plan, but mine is housed at Schwab (with Vanguard investments). Schwab also does a personal defined benefit plan for independent contractors. https://www.schwab.com/small-business-retirement-plans/personal-defined-benefit-plan
I am in a private practice surgical group with 5 partners age 35-45. We are looking at adding a CBP to our current 401k PSP plan. I understand this will allow us to increase our annual tax deferred contributions to about $110K each. By adding this we have to contribute some money to our employees. My understanding of the benefit is tax bracket arbitrage during retirement assuming that we will be in a lower effective tax rate in retirement than our current marginal rate. However IF there is no arbitrage and the rate stays the same do you lose all the benefit? You defer the taxes on the money put into the plan but not all 100% of that money stays with the partners so essentially there is some loss due to giving it to your employees. When you pull the money out at the same tax rate later you will have less than if you paid the tax upfront and didn’t give any to employees. Not to mention the fact that you generally shoot for a lower interest rate in the CBP to mitigate risk. I would appreciate any corrections to my thought process or explanations.
Not necessarily. If you know that you’ll end up in the highest brackets in retirement (which can happen) you can do after-tax + Roth (Roth salary deferral, after-tax PS converted to Roth), and still max out your CB plan. And then you will have the option of moving CB plan money to a 401k or IRA and converting it to Roth. This way you have tax diversification that is going to help you overcome any such issues. Whoever is advising you on the CB plan should take the time to explain all of the options to the partners as setting up a plan is not that hard, but understanding how to use the plan is where there are big gaps in the knowledge of plan participants.
You do have to consider the cost vs. benefit in this specific scenario. If the practice has only partners, this is probably an easy choice. However even with staff CB plans usually have high % to owner, so even in the case of the highest brackets in retirement you might still be better off doing it vs. not doing it. Remember that you contribute to the CB plan at your highest marginal brackets, but you make withdrawals/conversions at your average tax rate, so it would take quite a large income so that your tax rate in retirement = your highest marginal bracket in retirement, thus there is some differential involved unless your income keeps growing.
Make sure you understand this concept, it’s absolutely critical:
https://www.whitecoatinvestor.com/roth-versus-tax-deferred-the-critical-concept-of-filling-the-brackets/
The key when you think about “having to give money to your employees” is to get the employees on board. When they view that match as part of their compensation, then it’s no big deal. i.e. if you give them more in their retirement plan, you pay them less in salary. It’s all one pot of money to you and they need to understand that. For example, I have one employee who was paid $100 last month in her paycheck. The rest of her pay went into her 401k. She’s not upset at all as she basically chose for that to happen.
Other benefits of tax deferred retirement plan investing over simply investing in a taxable account include tax protected growth as it goes along, the time value of money (i.e. getting your tax break up front when it is most valuable), and additional asset protection.
I was eligible to start participating in the CBP of our big group last year. Started contributing in January and then covid hit. They gave us the option to stop contributing and I took it. Had about 30k sitting in the account. In the fall they decided to close the plan. We got slapped with $1200 closing fee (per person, our group is >100 people) and apparently some extra money to make up for losses. I was told the plan was invested very conservatively. The CBP has been the worst investment of my life so far. From now on I will stick with things under my direct control.
It sounds like a bunch of things went wrong here. Usually plans are just frozen, not terminated, but it does depend on the practice. First, I’ve never heard of $1200 per person closing fee, and we work with different actuaries and TPAs, so this type of fee is not something that makes sense. And if the plan was invested conservatively, why the losses? If anything in 2020 the bonds returned around 7%, so if the plan was managed prudently, there wouldn’t be any losses, at least not in 2020 or 2019 (there can be losses for sure, but they should ideally be small). This is why it is so important to manage the investments correctly because if there is a big loss and you have to close the plan, you have to make up for that loss (or the practice does). CB plan investments should be managed very conservatively because it is a type of plan that can be closed in any given year. This goes to show that it is critical to select the best service providers to manage big group CB plans. In the right hands this could be a great plan, but if it is not managed correctly you can end up with the results described above.
Thank you Kon, I appreciate your reply. It appears what we are short on is just the required IRS interest between the date of termination and the date of distribution (3.83% annual) so that is no big deal. It does appear however that the termination fee is $1358 per person. Could you share what an average termination fee should be like? Thank you.
Ok, so there is a PBGC fee and a termination fee. I was told by actuaries that PBGC fee can be as high as $582 (this has to be managed prudently as well, it is possible to minimize this fee with the right design). Then you have other fees that are incurred, so I would need to see an itemized breakdown (since I’m not an actuary and I don’t know off the top of my head what this can be for). I can’t imagine that this fee is higher than several hundred per person (so I would think that $20k might be fine for a termination fee), but it still does not add up to $1358 per person! That’s $135k!
So the only idea I have is that this is a total combined ‘fee’ that includes PBGC fee, termination fee and any shortfall/underfunding all lumped into a single number.
Thanks again. Appreciate your reply. When my group decides to start a new plan I will make sure they will consult with your company.
Can’t hurt to get good independent advice with these plans. I feel sorry for the docs who just started to participate and they get hit by expenses they never knew or anticipated. I can totally see why some might think this is a bad investment. One of the comments below talks about lack of transparency, so next time a group starts a plan they should do their due diligence and educate themselves about various types of scenarios so that they are better prepared next time.
This termination may have been strategic as well – nobody will question why a plan terminated during COVID, so it could have been timed this way, but communicating this to the group should be a priority.
Interesting and weird scenario. It might be interesting to get into the details.
I was going to post this to the retirement forum but this seems like a better place . Any advice appreciated. Physician spouse and I have had a DB plan for about 10 years. We pay $3400/ year to the firm that keeps it compliant and I manage the investments in a pooled account with Vanguard. We have accumulated about $2.2 million which is great but we just discovered that we are overfunded. Current ages 48, and we are looking at some form of retirement in roughly 5 years. Several years ago we stopped making 401k contributions because for payroll purposes it was easier to just make the DB plan contributions and the contribution upper limit was very high. Over the years I’ve asked our rep at least three times that I can recall whether this was a problem and whether there was an advantage to contributing to one versus the other and the reply was always no, they are equal, either is fine. In retrospect, this would have been a good time for his to warn me about overfunding.
I’ve just recently discovered, in part thanks to WCI, that we should have been filling our 401k first. The company receives annual statements from Vanguard and they track the balance, and we’ve been conservatively invested in broad sector index funds so this overfunding did not come out of nowhere. The first hint of a problem was Aug 2020 when our rep said he would advise contributing $0 for the year since we were close to overfunded. However, we had already made the contributions for the year at that point. The response was basically no problem, the max lump sum amount will increase every year and by age 62, the plan can be up to $3.3 million. BUT, If nothing more was invested and the plan stays open with current asset mix, we could easily have $5.5 million and I let him know that I wish this had been communicated sooner because we are on a crash course to major excise taxes due to the “magical” power of compound growth. Two months later, my rep invited me to a conference call with Mr. BOSS who I’ve never spoken to. It felt very much like a “CYA” call as no new information was given by them. Mr. BOSS said I should hold bonds or other conservative assets to throttle the growth of this plan, except that we don’t plan to own bonds or the like for another 15-20 years. The possible solution we came up with is that I will take a salary for a few years, which I haven’t done in many years, to hopefully boost our max lump sum enough to terminate the plan in the next few years to get ahead of the compounding growth.
So, this is a cautionary tale to others to be sure to understand the terminology and track the numbers yourself, and to fill up 401ks first.
Second part of this is a question. I am now paying extra payroll taxes on my salary of around $7,000 per year x 3 years to POSSIBLY get out of this problem without penalties. I don’t think I received stellar advice so I’m wondering, did they mismanage this and am I justified in asking the management company to waive my annual fee of $3,400 until we are able to start the termination process? Any other advice on rolling over an overfunded plan would be appreciated – I have learned that we would be allowed to roll over some excess amount without penalty but I don’t know how much that would be ?
This is a classic scenario where you didn’t have enough good advice from the very start. CB plans are NOT designed for growth. If your rate of return is say 3% and your portfolio returns 10%, once the plan is terminated, you will have to do either one of 2 things:
1) Keep it open for a very long time and pay admin fees to the actuary to use up the extra gain (which might never happen, even if you invest it all in the money market). This is terrible because you will be giving up the gains you could otherwise have if you terminate the plan and roll the money into a 401k plan and invest more aggressively there. CB plan is for 10 years only, so 3% isn’t such a bad deal considering the tax deduction.
2) Terminate it and pay 100% on any gains above 3% to the government. This is the only other choice that I know of.
I don’t know any other options available. Yes, you do have to put everything in bonds right now, and hope that you don’t have to pay 100% excise tax on any gains above the crediting rate. And you can probably contribute zero so you won’t get any more tax deduction. I’m not sure why this is is not explained better by the companies administering these plans, but they probably assume that you are working with an adviser who knows what they are doing. They are NOT going to advise you on your investments as this is not their job, so this is really on you to know this.
I wouldn’t recommend opening a plan for anyone until they understand this (or unless there is someone managing these investments who understands this).
Your actuary should provide advice to you on how to mitigate this situation, I don’t believe you’ll be getting any advice on this forum. I know a few things about CB plans, but some aspects are sophisticated enough so that you definitely want to get professional advice from an actuary.
You can always ask for a discount. I don’t see why they would HAVE to provide. I think you’d have a hard time successfully suing them, but I’m not attorney.