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.
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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?
Super dumb question. Did not notice it addressed in the text. Can a W2 physician open a cash balance plan for themselves? I am assuming no but figured I asked.
No, but you can try to lobby your practice to consider opening one for the group where the plan can be funded by you (rather than by employer). I’m sure many docs working with you probably don’t even know about these types of plans, and would be interested if they found out how they worked.
No dumb questions.
No, just like an employee can’t open their own 401k, they can’t open their own DBP.
Excellent post, Jim. As a prior trustee for a CBP, I can tell you it is extremely difficult to educate your partners on how these plans work. Also, having physicians manage these plans is often like the blind leading the blind. Another drawback of CBP’s is their lack of transparency. That said, they are especially beneficial in high tax states (e.g. California, New York).
That’s a great point. I find that groups can benefit from both good advice and also good education on the CB plan prior to adopting one. As far as transparency, this is easily reached as long as whoever is managing the plan is doing their job to both educate and advise the partners on the pros and cons as well as on how the plan investments should be managed for everyone’s benefit. There are so many misunderstandings about these plans given how complex they are, but they don’t have to be. These plans can be made relatively straight forward with enough communication between service providers. This is another missing link – actuaries are rarely good communicators, so if there is nobody on the plan sponsor’s side to bridge that gap, that’s where you get the lack of transparency.
I found this post and prior CBP posts very informative. The topic (and these plans) do certainly seem confusing. A question I still have is this: If my practice decides to offer a CBP plan, can the participants direct the investments of the profit sharing and 401K deferral contributions? As in, can these portions be self-managed while the CBP portion is per the plan’s design and specified investments? I apologize if I missed this in the posts/comments.
Yes. They’re actually separate plans.
They can unless your 401k plan is a pooled plan, just like CB plan. I still see those floating around, some are decades old.
two, maybe three questions.
1- is there any difference between CBP & DBP?
2- Our group [6 docs] have a DBP. We contributed heavily over 10 years, reached maximum actuarial allowed contribution. We are in the process of dissolving the plan, and rolling over $ to individual 401k’s/IRA’s. We have a side agreement of percentage ownership that goes from 7-21% depending on individual’s contribution over the years. Is our side agreement of percentage ownership kosher? does anyone know any IRS regulation that prevent side agreement?
1) There are some differences. CB plans have a hypothetical account value, DB plans don’t, so this makes it easier to understand CB plans by partners, as they are similar to profit sharing in a 401k plan. CB plans are definitely preferred for small group practices with staff given the pros vs. cons. But for a group without staff it probably does not make much of a difference. Actuaries like CB plans more though for multiple reasons.
2) I would talk with your actuary and/or an ERISA attorney regarding this one.
1. Technically a CBP is a type of DBP.
2. Dunno
Is a CBP appropriate/cost effective for a single 47 year old sole prop with no employees in the 35% tax bracket? I currently max out 58k SoloK/6k Backdoor roth/3.6k HSA. Due to paying off my mortgage in 2020, I am now debt free and therefore started a taxable brokerage account november 2020 for additional savings/investing. However, after reading about the consider tax savings for a CBP, I am wondering if the establishing a CBP as a single Sole Prop makes more sense than focusing only on the taxable brokerage after the Solok/Roth/HSA each year. Or, if the fees may be prohibitive since I would be a “1 person” CBP.
I will give you my non-expert answer [ from experince]
Yes CBP/DBP. You can put more than 100K/ year in your DBP[ your 404K/Roth will pale in comparison to the amounts you can put in DBP]
So you will have 58K/soloK/Roth/HSA/ DBP, then put extra in brokerage account!.
This is my non exerpt answer. wait for the experts.
If your family AGI is in the 37% bracket, then yes. If you are in a high tax state such as CA or NY, then also possibly yes even if you are in the 35% bracket (but you do need an income of at least $500k to make this work without any issues). CB maxed out over 10 years is going to beat a brokerage account even with a low return, if you are in the highest tax brackets. If you are in the 35% bracket, you can probably make the case for setting one up, but you need to be mindful of several things:
1) You would get the most benefit from running this plan for at least 5 years, but ideally 10. If you have uncertain future as far as 1099 vs. W2 vs. partnership, then I would skip it.
2) Be mindful of the costs. Starting/terminating this plan costs quite a bit, even if ongoing cost is reasonable. For that reason I’d say 10 years should be the target.
3) A net income of at least $500k is recommended for cash flow purposes (if you are older, I’d say at least $600k is better). Cash flow can be an issue even if your income is high.
Otherwise, I’d skip the CB plan and concentrate on the taxable.
Fees can be a pretty low on a personal defined benefit plan. I think last I looked it was something like $1200 to establish and $1200 a year or so.
I don’t think fees are this low, haven’t been for a while. Even Schwab is higher than that, $2250 startup and $1750 ongoing, and that’s bottom of the barrel. Anything better is going to be more like $2k-$2.5 ongoing if you are going to pay a TPA for both 401k/CB plans. Most docs would want to have both 401k and CB plans administered together by the same TPA/actuary, not just the CB plan, so it does add up. Also, there are termination fees that can be quite high ($2k-$4k depending on the service provider), so that should also be taken into account.
Thanks for the correction. I was thinking of Schwab’s product.
Thank you for the info
I’m 35% tax bracket and will probably never be in the 37% bracket as a single wage earner.
I live in Texas, so no state income tax although property taxes are not low.
I’m at approximately 400k per year -it varies since I am 100% 1099 income – esp with covid last year, the freeze this year, etc.
My saving rate is quite high now that all debts to include mortgage are paid off. I have 2 kids in high school, and I have saved most of what i am comfortable putting into a 529 by the end of 2021. No weekend home or expensive hobbies, Therefore, starting 2022 I will be predominantly focused on saving for retirement . I am not comfortable with a large bond portion to my porfolio, so If i did a CBP I would likely put in Vanguard Growth Fund VUG or VOO OR VTI, perhaps The Growth Lifestyle Fund which is 80% equity.
Ideally, as a single CBP, I could specify a minimum of 0 each year to balance any fluctuations in the equity portfolio.
Im ok with the 5 to 10 year time frame.
I currently put bond and bond alternatives in my self directed Solok ( mostly real estate debt funds).
I guess it really boils down to the fees involved and how much additional federal income tax savings can be sent to the CBP. I would love to lower my federal income tax bracket by using the CBP.
I’ll check with my CPA about the amount of federal income tax savings and the CBP fees.
Thanks again!!!
1. Does anyone have 10+ years experience with Cash Balance Plans and have you encountered any issues from the IRS?
2. Would a cash balance pension plan be considered a legal loophole for a solo independent contractor locums physician or is this a recognized and legitimate retirement strategy?
3. Does a $1,200 set up fee and $2,400/year accounting fee seem reasonable for a cash balance pension plan for myself only? For context I would plan to defer around $160K in taxes per year into this plan, so while the fees seem quite high at least there would be a considerable tax savings for the year I contribute?
Thanks in advance for all your help!
1) Biggest issues are not with the IRS. You need to have a very good TPA/actuary who can guide you and make sure you are not making mistakes and doing things wrong. There are many ways to mess things up, from over-funding the plan to hiring employees if you have a solo plan.
2) CB plans are just as legitimate as 401k plans.
3) This seems about average if both 401k/CB plans are administered together (which they should).
You also need to be aware that your PS contribution is limited to 6%, so this means you can do MBR 401k for the rest up to the maximum ($61k). Your TPA/actuary has to know how to do this to advise you on the process (it is tricky as you need to set up an additional Roth account), as this can be quite a large amount (possibly as much as $20k) that you don’t want to miss out on.
1. Yes. No.
2. Totally legit. Just like a legal loophole would be. Why don’t you think something that is legal is legit?
3. Yes, that’s kind of the going rate.
Thanks for your replies. I have a follow up question but first wanted to provided some context.
Late last year I decided to proceed with opening a Cash Balance Plan with Emparion after vetting a few of the TPAs endorsed by this site. I went with Emparion mainly because during the sales pitch, I was told that I would be able to defer $160K each year for 4-5 years, terminate the plan, and roll this money into a solo 401K.
For context, I’m 34 yo and would plan to potentially terminate the plan in 5 years if/when I transition from 1099 to a W2 position. The idea is to not terminate the CB plan, but I’d like the flexibility to do so if my practice changes.
I recently had a phone call with Kon who mentioned that if I contribute $160K/year at my age and terminate the plan in 4-5 years that I may run into major overfunding issues which would cause significant tax consequences. Unfortunately, this was never something that was shared with me during the initial sales process at Emparion and I have already created my plan with them. I have since spoken with Paul at Emparion and he mentioned that if I am overfunded and plan to terminate I should simply leave my plan open for several years longer (all while incurring administration fees) until I am no longer overfunded.
My question: is there something unique to Emparion that allows them to provide a greater amount of tax deferred contributions than the other TPAs? Are some TPAs able to create actuarial projections that allow for more tax deferred contributions than others? OR is it your understanding that every single one of these TPAs needs to abide by the exact same actuarial projections and the amount of tax deferred contributions that you can make in a 5 year period will be the same regardless of which TPA you choose? I ask because in the event that there is variance between these TPAs, then it would make the most sense in my situation to go with one that would allow for the most aggressive amount of tax deferred contributions.
There are several variations on the types of designs available for solo plans, and some are higher risk than others. The formulas are all the same, so all actuaries have access to them. Your lifetime maximum is a hard-wired constant that can not change, so at the end of the day, ALL designs will allow you to contribute the same amount, albeit at a different schedule. The problem is that some unscrupulous actuaries/salespeople want to entice younger docs to open a CB plan, so they try to present the front loaded scenario without adequately explaining that the account might have to remain open for longer than 10 years, especially if there are gains in excess of the crediting rate, unless you want to forfeit a good portion of the gains. Not only does this incur extra fees, but at some point you lose control because either your investment is in the money market (returning very little, until recently that is), or it is in higher risk/higher volatility funds that can potentially make the situation worse. Also, in some cases you might no longer want to maintain this plan due to various business issues, so if you have to terminate your plan early, the front-loaded version is very high risk.
There are some creative solo designs that I’ve seen that avoid the front-loading problem, but you are not going to get as aggressive in funding the plan in the first 5 years. One actuary I know does 1 year on, one year off (front load for 1 year, contribute nothing the following year). This avoids the really bad overfunding that can happen with 5 year front-loaded design. Also, there are many docs whose 1099 income is not exactly rock stable, so if they have to terminate the plan early, they wouldn’t be able to due to this front loading. The idea is that 10 years is the longest amount you need to max out your plan. Anything longer is not necessary as you will reach your lifetime maximum at maximum contribution in 10 years.
What you want is the best actuary that actually explains their design and its pitfalls. A company that is run like a mill that sells front-loaded designs without doing their due diligence (especially to younger docs who would otherwise not be able to make substantial annual contributions using regular design) and without making sure that it is appropriate in each and every situation (and without providing a good explanation of what will happen if the plan is overfunded, which is a very real possibility when you max it out in 5 years) is not the right one for someone whose 1099 income situation can change quickly. Most actuaries will not talk to anyone who is younger than maybe 35 at the very least. Anyone who is trying to sell CB plans to under-35 docs without studying their situation in detail and making sure that this type of plan is the best one for their specific situation is doing a big disservice to younger docs.
Any doc setting up a CB plan should be told that a 5-year front-loaded plan can run for longer than 10 years, and that it can not be terminated sooner than 10 years without forfeiting some of the gains, because it is specifically designed to run for at least 10 years, longer if gains are larger than the crediting rate (of course this does depend on how much it is front-loaded, but the numbers provided seem like it would be maxed out in 5 years or less). If the actuary is not doing that, they are doing a sales job, nothing more, to entice younger docs to participate in a plan that is most likely not appropriate for them until they get older and can contribute more without front-loading.
$160K is a huge contribution for someone as young as you.
I wonder if you can make some smaller contributions in years 3-5 if it’s starting to look overfunded.
Even if you do have to pay some admin fees to keep the plan open a little longer, it may still be worth it to have such a huge deferral.
Compare this the contribution for a 35 year old doc in my partnership DBP: $5K. Even my contribution is only $17,500. That’s probably more conservative than it has to be, but it’s a long way from there to $160K.
Thanks for your quick responses. Please let me know if my understanding then is correct:
The maximum amount of money that I can defer over a 5 year period is essentially a fixed number regardless of which TPA I employ. In other words, no matter which TPA I use, the only variables to consider should be the costs and service received. No one TPA can can help draft up a plan that allows me to defer substantially more over a 5 year period than another given that the lifetime maximum deferral limit is a hard-wired constant.
If this is true, (roughly) what would that maximum 5 year deferral in a CB plan be for a 34 yo?
No, not over 5 years. Over 10 years. The maximum is calculated assuming you are contributing the maximum over 10 years. So what you can put into your plan over 10 years is the same amount, whether you frontload over 5 years, or whether you have a fixed/constant contribution over 10 years. You can’t get any more money if you run the plan longer than 10 years. If you have to use up the gains over a period longer than 10 years (or over a time period that is essentially a variable that you have little control over) that’s a bad design. Your plan can easily be designed to be maxed out in 10 years, and you don’t need to run it for longer than that but your contributions will be a lot lower, more like $85k, not $160k. The problem with overfunding over 5 years is that the plan can remain open for longer than 10 years to use up the gains, and that’s a defect that does not need to be there as the amount you get into the plan is maxed out at 10 years, so the rest is just paying actuarial fees for nothing at all.
The design you got is a 5 year front-loaded one with the idea that after 5 years no more contributions are made. A 34 year old opening a CB plan can contribute about 1.35M into the plan over 10 years, plus some inflation adjustments that are done every 3 years or so. You can put away this $1.35M in 5 years, but then over the next 5 years the assets can grow, resulting in overfunding. That’s why this can remain open for longer than 10 years, but your overall contribution won’t be much higher than $1.35M. Also after 10 years do you want to roll this money into a 401k if possible, as it does not pay for you to keep it locked up in a low volatility (usually all bond) investment.
Just to clarify. You can certainly participate in a CB plan for 5 years only. You can make level contributions that range from $85k at age 34 up to $105k at age 39 so the total might be shy of $500k or so. Front loading if you want a 5 year plan (that terminate after 5 years) is just plain nuts.
The answer to the first question is yes. That’s all actuarially determined. I don’t know the answer to the second though. I’d have to ask an actuary.
The problem is that the actuary hands the doc this design with a specific idea to overfund over 5 years. The problem is not just paying admin fees but being handed a plan that’s too risky because it can’t be terminated quickly and because might have to stay open for longer than 10 years for no reason at all! If your maximum is fixed, there is no reason to do anything else other than make annual contributions over 10 years. This is just a sales job with solo DB plans (to sell the higher contribution), I don’t know any reputable actuary who would do a 5 year overfunding with the idea of keeping the plan open after that. And worst of all, they are not telling the doc about this – it is a feature, not a bug.
I am 48 in solo practice with 4 young employees and I offer a 401K to my employees. Due to a seemingly irreparable ASG/control group exposure, I’m unable to participate in this 401K or other qualifying plans (CB). This sucks as I can not take advantage of benefits of single member llc ownership with funding the plans for my family.
How much is this lack of participation going to impact me? What other tax advantages retirement vehicles are available to me? I’m most interested in those that mitigate tax exposure in retirement but wouldn’t mind some breaks while as a working stiff as well.
First, it is unclear what you mean by ASG/controlled group exposure when you’ve only named one practice. Did you mean that you also have an LLC through which you pay yourself? Why can’t you participate in your own practice 401k plan?
I have ownership in a surgicenter with several other surgeon groups. When this surgicenter was setup, no one addressed the control group issue. It remains an outstanding issue. When I transitioned to solo practice and went to setup plans for my employees, the issue was discovered.
This has been confirmed by my TPA and 3 national ERISA attorneys. My surgicenter partners differ in their stance with my tpa and 3 experts….
Are you better off continuing to own the surgicenter and not having a 401(k) plan at the practice or selling the surgicenter in order to do so? I suspect the former.
At any rate, you’ll still be able to do a personal and spousal Backdoor Roth IRA each year, an HSA, and invest in taxable.
Thank you for the reply. Would you please generalize the maximum dollar amounts allocated to each account?
Other options would include taxable accounts, real estate, or perhaps maximizing vertical integration in whatever businesses owned: ie, owning the lithotripsy center, another dialysis center: becoming a REPS /owning a prop mgmt llc for any commercial or residential properties owned?
Thanks in advance. I trust the opinions I’ve accumulated and the TPA’s stance. It’s really frustrating to not have these relatively mindless (401k, CB) options available to me especially in light of being a business owner.
If you’re under 50, Roth IRAs are $6,500 a piece per year, HSA is $7750 this year for a family. No limit on taxable account whether it is invested in mutual funds, real estate, insurance products, small businesses etc.
In your situation think of the retirement accounts as a icing on the cake, not the cake. It’s okay to save for retirement outside retirement accounts if none are available to you. Most of our savings now goes into a taxable account. It’s a good problem to have because it usually means you have a really high income. Joe Average doesn’t save more per year than he can put into a Roth IRA.
Thank you
1) This sounds like it is not a controlled group, it is an affiliated service group.
2) Depending on the facts and circumstances it might be possible to go around the ASG. There are ERISA attorneys and there are ERISA attorneys. While identifying an ASG is not difficult, fixing it requires some creativity. And even then it is not always possible. What is % of your net income that you get from the surgery center?
3) Setting up a plan for your employees is not going to avoid the ASG issue – you still have to test this plan with the plan for the surgical center/other ASG members if there is an ASG, so just because you don’t participate, that does not absolve you from the responsibility to be in compliance. If there is an ASG then all involved parties should be setting up a single plan for all entities in the ASG. This might actually not be a bad idea as it will cut down on the costs, and if these are similarly sized groups it might be possible to even set up a Cash Balance plan, but I’m guessing some of these groups probably have their own independent plans and probably don’t care about ASG (I’ve seen this too).
We’ve run into this issue multiple times. Depending on the facts and circumstances it is often possible to proceed with a plan even though there are ASG concerns, provided an ERISA attorney can find an appropriate solution. If an individual solution can not be found, going with a single plan for the ASG is often the best solution.
My Anesthesia group of 12 guys does a DB plan using an actuary. I’m currently W2 but will become a 1099 partner at the end of this year. I’m married and expecting to make around 550k next year(wife is stay at home mom). I try to reduce my taxable income as much as possible because I pay 10% of my AGI to federal loans(380k at 6.8%), waiting for 20 year forgiveness on my current plan (I’ve already put in 7 years)
I was planning on putting 150k or more into the DB in addition to maxing out personal 401k.
Here is my question: Can putting money into the DB help me qualify for the 199A deduction? Should I just put as much as i can afford into the DB or should i limit it to take advantage of the 199A?
You should definitely ask your accountant to run the numbers for your situation as this does get complex. It looks like you might be able to get maximum QBI deduction if you use both 401k and CB plan ($66k + $150k) in your scenario.
Thanks Kon for the reply, I have been reading some of your other comments and I am a bit concerned about my small group’s DB plan. They say I can donate as much as a want (I’m 40 yrs old) and that it ends up in a self directed account with no limits on growth. Our practice is set up as an ASG and each partner has a dedicated retirement LLC that holds our DB and 401k funds. A CPA completes each retirement LLC’s tax returns and sends them to our actuary that is the plan administrator who files 5500 forms, we also have a plan attorney.
I guess I’m just concerned because compared to other plans I have seen, ours seems too good to be true. I want to just trust our group but I don’t want to end up with big problems after putting years of my retirement money in the DB. Thoughts?
Are both 401k and CB plans (vs. just accounts in the name of the plan) set up by each individual partner?
No, you can’t contribute as much as you want – maximum is $110k for a 40 year old at this time, and no actuary worth their money will advise you to overfund your contributions (this is the worst possible strategy, technically possible, but highly risky). Also, even if you have actual rate of return plan, there will be a 5% or 6% cap, so no, you can’t earn as much as the market can get. But that’s not even relevant in a CB plan.
A 401k plan can technically be set up by an individual partner (is it a solo 401k or just a brokerage account in the name of the plan)? A CB plan has to be set up by the practice, not by each partner. But if one wants to get gimmicky, you can technically have participants open their own accounts. This is going to get very dicey as you still can’t go over the cap, so managing multiple accounts that can go all over the place is very risky as well since in a CB plan individual return does not matter at all. If one partner make 20% and the other one loses 50%, all gains and losses are still aggregated into a single return, and every participant gets that return, not their individual return. Unless of course somehow they set up individual CB plans for each participant (which would be illegal).
If your attorney is not of an ERISA variety that’s not very helpful as non-ERISA attorneys know very little about these types of plans. So it would be important to establish facts first as based on your description it is still not clear who sets up the plans (individuals vs. group).
So it sounds like the inmates are running the asylum in this case – service providers should have never allowed this to proceed as it sounds like this is exactly the type of scenario that results in lawsuits and potential underfunding issues when partners leave and the group has to make up the shortfall (again, assuming at the very least that a CB plan is set up at the group level).
It is set up by the group but both DB and 401k money ends up in a individual self directed investment accounts. The money from both DB and 401k ends up in the same individual non-prototype account. I write a check to our group trust and then it gets deposited into my retirement LLCs account. They keep telling me there is no growth limit and i can invest it in whatever I want. The plan attorney is an ERISA. Should I get another ERISA to look things over before I join the plan?
Wow, this is nuts. Absolutely, I would find an ERISA attorney and have them review this arrangement. I’ve never heard of commingling 401k and CB plan money. How did they arrive at $150k contribution amount?
I agree. Something weird is going on here. No way should those funds be commingled. They might just not be communicating very well to you what is going on because they don’t understand themselves. Make sure you’re talking to whoever is running this plan and not just your potential future partners who might not really understand it.
It turns out that commingling funds is a possibility. This is probably an old way of doing it, but in the past this is how some plans did it, despite the obvious issues that this brings about.
There are many more issues with this plan, and unless they have it all running smoothly and planned out perfectly, I would stay away because there are significant issues here related to funding volatility. They can only take home a lifetime maximum, but having unrestricted investment returns and unrestricted contributions is a sure recipe for a total disaster down the road, especially if some partners with lots of assets do stupid things, and potentially leave taking 100% of their account value with them, requiring the rest of the partners to bail them out.
There are just too many variables here that can create issues from all types of angles, so this is really the worst way of setting up a plan (but it sure is ‘low cost’, which is probably why they did it like that to begin with). ERISA attorney supposedly overseeing the whole thing doesn’t add any confidence whatsoever.
I am opening a cash balance plan and was going to aim for a 50/50 mix of VTSAX/VBTLX to be nice and boring and conservative. Does this sound reasonable or would you change those ratios? What do you have in the defined benefit component of your cash balance plan?
Thanks.
This is nowhere near conservative. It is extremely aggressive. This allocation can easily lose 25%-30%, so it is totally inappropriate for a plan that will be around for at most 10 years (and potentially even less than that). Just the total bond market fund lost about 13% in 2022, which should already disqualify it as a CB plan investment. Given that crediting rates are around 3%-4% there is no reason to have any stocks, and bonds have to be properly selected based on their risk (duration).
Is it wise to do all bond index in CBP?
A Cash Balance plan is an account where you accumulate a lifetime maximum lump sum that is fixed, with the ability to terminate this plan after 4-5 years (at which point you have to make up any shortfall). If your return is very low (especially closer to plan termination), you will have to make it up to yourself (potentially 2x to 3x your annual contribution) and if your return is too high, you will forfeit to the government potentially up to 100% in excess of your crediting rate. With these constraints, and because you know you need the money after a fixed period of time while keeping your principal as safe as possible, what type of investment do you think will would work best?
Depends on how much of an issue it is to you to make a shortfall. It isn’t to me so I’m perfectly fine with my DBP allocation, the VG Lifestrategy Moderate Growth Fund. But lots of people (and actually the default, you have to opt out to avoid it) for the last year before we close it next year is actually a money market fund.
If I am 42, making 500K+ independent contractor, LLC filing as S-Corp, and I have the ability to put aside a decent amount extra each month, what IS the right amount to anticipate funding this thing each year (assuming I am trying to do the right thing and keep it open about 10 years), and what SHOULD the portfolio (just the DBP component) consist of? And if I plan a full 10 years i shouldn’t have any shortfall issues, right?
Define “decent amount” and maybe someone can answer the first question.
As a general rule, take your risk in the 401(k), not the DBP. So if you’re putting and have equal amounts in boht, perhaps the 401k is 100% stock and the DBP is 40/60 so your overall is 65/35 or something like that.
10 years will probably keep you out of both shortfall issues and IRS scrutiny. 5 might be plenty honestly.
Thank you for the response and for all that you are doing.
We are picking an interest credit rate of 4 percent. In today’s environment, should we do a treasury bond ladder, something like some 3-month T bills, 6-month T bills, 9-month T bills, or 1 year T bills? Or is one 6-month T bill, ok? Do you put the money in the cash balance plan all at once before the end of the fiscal year for simplicity and to get it done with? Or do you put it in gradually? Is that 4 percent over one year? Annualized from when we put it in to when they calculate the final amount? We need to dump in about 250k to our CBP. Can I simply buy a two-year treasury bill with the 250k and be done with it? There is a concern that if interest rates change the 2-year bill could be marked to market and show a loss or gain?
That sounds like an awful lot of active management of the portfolio. Just for comparison our CBP uses a single, relatively conservative, fund of funds. You probably can do a ladder or T bills if you want though. Why not discuss with the company setting up your CBP? It’s not typically a DIY project.
My CBP contributions go in monthly. I think that’s typically how people do it. Yes, I assume the return is annualized. If individual bons are held t maturity, there is no loss or gain due to interest rate fluctuations. You’ll be buying your next bond at the new interest rate though of course.
Individual bonds are not the way to go. It is indeed very complicated to do, especially if you have a group plan, and it is also quite risky as you will not have enough money to pay distributions to departing partners, so you would have to sell investments, potentially at a loss. This may not be as much of an issue with very short bonds, but with those bonds you would be constantly reinvesting, and that’s a lot of work. If you stick to the short end and and interest rates go down, you would have to scramble to get into the intermediate bonds, and by then the prices would have gone up, so again, that’s not how you build ladders for CB plans. There are ways to build ladders that don’t use individual bonds, but rather bond funds, and that’s how one should be doing it.
Many groups make contributions on a quarterly or a monthly basis. One reason to do it is to dollar cost average into an investment, as bonds do exhibit volatility that can be significant at times.
I’m surprised at the line of questions, especially if this is a group plan (‘we’ is what I’m going by). There should be an adviser managing your plan. They should have advised you on all of this by now, and explained their investment strategy.
Do you think a single investment in the Vanguard intermediate term bond fund like VSIGX would work?
Do you have clients simply use the Vanguard Target Retirement 2020 fund VTWNX? What would be the problem with that, if any?
Average duration on VSIGX is 4.9, and that’s not even fixed, it can very. This is huge. If/when interest rates change, this fund will move quite a bit. In 2022 it lost probably around -12.15%, so this is not an appropriate fund for a CB plan given how volatile it can get. We try to keep duration to 2 and under, at least in the current environment. Also, portfolio composition is a problem for these funds. They have exposure to longer duration bonds, this is what causes some of the losses.
Target retirement is even further from the ballpark. You got a bond component and a stock component, both volatile. In TDFs, bonds are total bond market, which is even worse than VSIGX as the duration for that is higher. That one went down -16.27% in 2022. These are not the types of investments you want for a CB plan that will be around for a while.
That’s why I prefer to build my own ‘bond fund’ with a specific duration. This is how you limit risk. It is not only during bad years that you worry about it, but during good years you can have high volatility, so it is possible to get a lower return than the fund if you made contributions during the year at exactly the wrong time, if your investment is very volatile.
You have to consider not only the probability of risk showing up, but also the consequences. The consequence of shortfall due to poor returns is that you have to make additional contributions to the account, which you also get a tax deduction for. That’s not the end of the world if you’re a good saver and the CBP is relatively small. But it does bother some employees/partners to have to come up with a bunch of cash to contribute and possibly do so when the economy is not doing so well. The less significant the consequences of shortfall, the more risk you can take in your plan. But I agree with Kon that it is best to take risk in your 401(k), not your CBP. It’s a good place for your bond allocation.
Yes, and wait till they hear about having to make up the shortfall for departing partners! This is always brushed under the rug by service providers. I hear horror stories about this (and I’ve experienced this in one of our plans). They have no idea until it hits them. Some plans are simply unprepared to handle this type of event, and having high risk portfolios makes it so much worse.
Individual plans are very different – one can have any reasonable allocation there, but group plans are a powder keg if not managed properly.
Do you see an interest credit rate of 3 percent in any of your group plans? We are a group of doctors that are exploring options. The VTINX (Target Retirment Income Fund) has a nice average (5 percent) but yes in some rare years there will be a large loss or a large gain. Why not just put all of it in the Vanguard Treasury Money Market Fund? If interest go down then other actions would need to be taken, but if interest rates are ok, then it should be very easy, especially with an interest credit rate of 3 percent.
Yes, the range is from 2% to 4.5%. The average return is not relevant. We want something that on an annual basis has extremely low volatility. If/when interest rates drop, money market will drop with it. And at that point bond prices will rise, so you would have to be buying overpriced bonds. Money market is fine if you are terminating the plan and want total asset stability at distribution, not so much into an interest rate that will go down eventually.
Regardless, for group plans there has to be an adviser present, ideally in an ERISA 3(38) capacity. It is very much possible that nobody told you about having to make up shortfall for departing partners. There are just too many things that go wrong with CB plans, so trying to come up with an investment strategy for a pooled plan with many partners is not what you want to be doing.
But why then does the WCI ER practice use the 40-60 Life Strategy Fund? Aren’t they taking too much risk? Or do you not agree with their approach, as reasonable people can disagree sometimes. Can you elaborate on the risk of a departing partner and give an example? That makes me nervous. Thank you.
Single owner! No partners to worry about, all HCE staff. This is not a plan you will find anywhere on the planet other than at WCI! So their choices are unique to their plan. I would never recommend any risk like that even with HCEs because if the market goes down, you have to make up the shortfall as the owner, but if HCEs contributions are not very high (say $20k each), then the risk is relatively small, though if you have many such staff, it does add up over time.
With partners who are contributing $100k-$200k+ each year, the magnitude is much larger. If a partner leaves and the market is down, the practice has to give 100% of the account value to the partner! If your service providers didn’t discuss how to handle that, you are in the same boat as all of the other practices whose providers didn’t tell this to them, and then they experienced it first hand, and had to make whole departing partners by covering any shortfall.
To be clear, the CB plan I refer to is NOT a WCI company plan. The only retirement plan WCI has is a 401(k). The CB plan I am referring to is my physician partnership plan. The risk of partners leaving and having to make contributions on their behalf is lowered by closing the plan and starting a new one as frequently as possible/reasonable. But it is a risk and those on our retirement plan committee understand it. Whether every doc in the 400 doc group understands it is a different question.
But I’m comfortable with the risk of having to make up for losses in MY account. I save much more each year than that CB plan contribution. The risk of having to fund it for retired docs would be diluted over so many other docs I’m not too worried about that either. Frankly, few people are even contributing at my level ($60K/year) and almost no one is doing the maximum $120K a year in our plan. Yes, it’s possible to have a moderate one year loss in a life strategy 40/60 fund. In 2022 it lost 14% and 3% in 2018. I think our minimum crediting rate is 0% in the plan. But when you have a return over the maximum crediting rate, those gains are first used to offset the losses before additional contributions have to be made. When we went to close our last plan we looked to see how many people who have to bring money to the table and it was almost no one and even those who had to it would be a trivial amount. So there is risk there, but I’m not sure it shows up all that often even with a “risky” 40/60 kind of portfolio.
But I agree with Kon that it is perfectly fine to just use a short term bond fund. You’re not trying to shoot the lights out with CB plan returns. Take that risk in your 401k and taxable account. With a CB plan you’re just trying to save some tax money and get more money into retirement accounts long term. There is a downside to having too high of returns in the plan. A big excise tax as I recall. 50% maybe. For money in the plan when it is closed that is in excess of the crediting rate.
If enough docs retire/move on, this can create an avalanche, so as always, steps have to be taken to protect the group from such losses.
Also, when there is a loss, I’ve seen even groups where many partners can make the contributions end up freezing the plan because as a whole the group may not be willing to do so. Again, another big risk.
If you have an actual rate of return plan, it is true that crediting rate can be zero, but these plans are much more complex and have other pitfalls, especially if there are any NHCE employees, so most high level actuaries avoid these. One still has to make up the shortfall up to zero when retiring/terminating, so if there is a big shortfall that’s not much help.
I honestly don’t see the use for a plan where you are limited by $120k contribution. I believe contribution should be individually designed so that anyone can contribute any reasonable amount up to the maximum, but some plans do have ‘tiers’ of contributions.
Yes, excise tax for over-funding can be as high as 100%. But most of the practices adopting these plans are nowhere near as large, and their goal is to stuff the plan full of money in 8-10 years, terminate and restart, etc., so for those groups individuals bear all of the risks is the plan has high volatility investments and the group does not have a handle on how to manage departing partners when there is a shortfall. Most of the problems stem from underfunding, not overfunding, that’s for sure.
Yea, we have tiers. But I think you can get into the max tier ($120K) starting at 46 or so.
We also don’t make/save that much money. A typical full time emergency doc only makes $400K. $70K into the 401(k), $7K into a BD Roth IRA, and $120K into CBP is like half your income. And few of our partners max out their 401(k) ($70K) much less the DBP. So there is little need for a $200-300K contribution tier in our group. We also don’t let the NHCEs use the CBP. Apparently we still pass non discrimination testing. Haven’t looked into that too closely. It is interesting to get a view into the anonymized data to see how little most docs save for retirement. Yes, WCIers are trying to max these things out but few of their colleagues are.
Got it, this makes sense now. Tiers make it much easier if the goal is much lower. Those plans are also more stable than typical plan where they shoot for the moon as far as contributions. This is not a typical plan, btw. Smaller groups typically want to max out their contributions in 10 years, so they are all individually designed.
Yes, those who ‘only’ make $400k probably don’t save as much as they should. And they probably also start late unless they find WCI. Right now there are some threads on DT where even saving $2M during their whole career may be a stretch for many dentists. Doctors should be happy they are making $400k with zero overhead and a need to run their own practice.
When we started our DBP, we ranged in age from 31-57 years old. Only 8 docs. Each had maximum contribution limit. Some of us contributed upward of 200k/year for years. Since the DBP investment is one single account, we had side agreement,( memorandum of understanding )who owns what percentage of the plan depending of percentage of contribution. . Couple of partners left earlier, calculations were simple, you own X% of the plan, and monies were transferred to their respective 401K accounts. We stopped contributing to the DBP account years ago based on accountant recommendation to avoid overfunding.
We survived an IRS audit.( the plan was fined 15k, don’t even know why ) but we had total assets north of 10 millions dollars. We survived the IRS audit, closed the DBP, and distributed monies to partners depending on percentage ownership of the total DBP balance.
The best investment I ever made. My DBP assets easily beat my 401k balance. Now all the money sets in my 401K.
Once again, best investment I ever made.
Jim,
For a doc in your ER group that puts in 60k, and another doc puts in 120k—how do you reconcile the salary? Is it every December one doc gets a bonus of 60k LESS because that 60k went into the CBP? So that doctor has a W2 income of not 400k but 400k-60k=340k? Same with the 120k doctor. That doctor has a W2 income of 400k-120k=280k? Do you reconcile this monthly? In real time as the CBP is funded? Or is the base salary decreased by 60k for that 60k doctor and the base salary is decreased by 120k for that 120k doctor CBP contribution?
Usually the money gets put aside every month or quarter, and rather than waiting until the tax time to contribute, you would want to make periodic contributions. This is actually pretty simple to do. This does not come out of W2. This comes out of net profit/distribution. At least, that’s how it is for shareholders. You must have a W2 that’s high enough to allow the right amount to be contributed, for those who want to max out for example. And this is an employer contribution.
If you have an employed W2 physician who is allowed to make a contribution (which sometimes happens), in that case you take it out of their W2. But with shareholders this comes out of the net profit/eventual distribution amount. This is why we would want to see $345k W2, and enough money left over so that contributions into PS and CB can be made for the shareholders.
We don’t get W-2 income. All K-1. And the CBP contributions are pulled out of our distribution every month. When I wasn’t working last Fall, I had to write a check each month for the contribution.
Can you amend the plan after two years and remain in compliance? Can you change the interest credit rating after two years? Can you change the contribution amounts after two years or is that not legal? Say a new partner joins the partnership after one year, can you amend the plan then and change contribution levels? Is it legal to shut down a plan after 5 years and start a new one?
You should typically change the contribution no more often than once in about 3 years. Sometimes you need to amend after 2, but that shouldn’t be the rule. And crediting rate is not something you would typically change until you terminate and restart the plan. Theoretically you can change it, but I’ve never seen anyone do it before, usually that’s at termination and restart. Contribution amounts – after 3 years is the consensus, but some actuaries do things differently. Just because someone joins doesn’t mean you can change it for everyone after 1 year for example. No, 5 years is high risk. Consensus is about 8-10 years for terminate AND restart to satisfy the permanency requirement. You can terminate after 5 years, but immediately restart – no, though some actuaries would claim yes. I would run, not talk away from them. Lots of good questions. Sounds like your service providers aren’t even close to be doing their job. These are the types of things we discuss with the group in great detail before they start the plan. No wonder many CB plans are a total mess…
We are W2 doctors only. We don’t get a k-1. If a doc makes 475k, and puts in 50k, the W2 in theory will go down to 450k. But if that doc puts in 200k, the W2 gets too low (475k-200k=275k) to do this CBP, right? The money is not coming from W2, however the W2 is going to be lower because the medical practice has less revenue and more expense. Is that the way to think about it? Kon, can you do the CBP, and our usual people do the 401k and profit share? Or does it all have to be together with one helper? What do you think of 50 percent in Vanguard Treasury Money Market and 50 percent in Vanguard Short Term bond fund for the pooled CBP money? Interest credit rate would be 3.5 percent, I guess. Or should it be 3 percent?
So you are C corp where everything is paid out via W2? In that case yes, you would decrease your W2 by that amount, that’s correct.
Yes, not everyone has to do the CB plan, if I understand your question correctly. But the design has to reflect that. If you don’t have enough participants for a PBGC plan, other partners’ PS contributions will be limited to 6%. This would have to be resolved.
Interest credit rate is set by the actuaries, not by the plan sponsor, and it is based on the design of the plan. This gets pretty complex fast, so it is not DIY project.
I love the problems WCIers worry about and try to optimize. Go talk to a group of docs making $450K and ask how many of them want to put $200K into a CBP. That’s got to be a single digit percentage.
To be fair, they do have to commit to it, and that’s not something everyone would be willing to do, especially knowing that they can only change this amount once in 3 years. Also, many are younger with families, and once they have more than 2 kids, it starts adding up (larger house, more expenses for everything, etc). That said, there are docs making $600k+ who can barely swing a 401k with profit sharing.
Jim,
What is the interest credit rate on your 40-60 Life Strategy CBP? 5 percent? May I ask what company you use? What percent of the benefit goes to the owners versus the staff? I have heard about 80 percent plus at least is what makes it worth it from a feasibility standpoint.
Do you get a statement each month or only once per year?
Just to clarify the terminology. Crediting rate is fixed. It can be 4% or 5% (which is a bit high, but older plans have 5%). Investment return is not related to the crediting rate. It can be higher or lower than crediting rate. Life Strategy average return is not relevant as past return average does not guarantee future return average, and over a short period of time it can be anything (high, low, in the middle, etc). The only thing relevant about it is that it is very volatile, and will result in issues when either terminating the plan or paying out terminated participants. So saying that fund X has a 5% average and your crediting rate is 5% is like saying that you are 6 ft tall and will cross a river that’s on average 6 ft deep on foot without any trouble. You will most certainly have trouble crossing this river on foot. This is exactly the same thing.
Actual rate of return is a type of plan that credits the return on investment as the return for the year, capped at 5%, and some plans are like that (sounds like WCI’s plan is ARR). CB plans are valued once per year, so you would expect a statement once per year. There are some service providers who do daily CB valuations, but these are extremely expensive (and also unnecessary).
Have you seen examples like that where plan had trouble due to volatility? Did the practice come up with the money and were they angry? What are the disadvantages of the actual rate of return plans? We interviewed one provider that said it was not good and too complex and would not work. But it sounds like the perfect solution. Why are old plans 5 percent and new plans lower than that?
We have a actual rate of return plan with limits of 0-6% I believe. NWPS I believe. It’s pretty much all owners as it’s an emergency doc partnership so not much staff. The APCs and pre-partners aren’t eligible and that’s most of the people at the company that aren’t owners. I can log into the website at any time and there are probably statements there, but I don’t get them in the mail.
We work with NWPS. They have a login via Schwab. Statements are probably electronic, at least that’s how I get everything from them.
That sounds right.
Have you seen examples like that where plan had trouble due to volatility? Did the practice come up with the money and were they angry? What are the disadvantages of the actual rate of return plans? We interviewed one provider that said it was not good and too complex and would not work. But it sounds like the perfect solution. Why are old plans 5 percent and new plans lower than that?
Angry, they were livid. They had to come up with $150k for 3 partners, and didn’t take any action despite warnings that this could happen. There are tons of stories like that. That’s the reason I’m sharing this with everyone who wants to start a CB plan. If you don’t have the framework in place, the practice would be paying every last penny for the departing partners’ shortfall, you better believe it.
ARR plans don’t work well if you have any staff. They are generally much more complex and have downsides. Most good actuaries prefer fixed rate of return plans. Also, these plans don’t like volatility either. We consult on this for groups, it is an important decision to make.
Older plans are 5% was because they needed a higher return to make them work. Funny enough interest rate back then was zero, but crediting rate was 5%. Interest rate is about 5% now, but crediting rate is lower.
So what do you tell groups to pick for the credit rate? 3.5 percent? It seems random in a sense. Is it right to think that the lower the rate the safer and more conservative it is? What if you pick a rate of 2.5 percent and you get a return of 4 percent? Will you be in trouble?
The actuary selects the rate based on plan design, so its not random but based on considerations that are not apparent/obvious. Year to year variations that are relatively small are not particularly important. However, large deviations would be a problem. Also, once the plan has been around for a while, even relatively small deviations can create issues. For example 5% shortfall with a $3M portfolio is $150k, which is quite significant, so those with larger portfolios will have to make up more $ than those with small portfolios, thus terminate and restart to reset the assets in the plan to minimize this type of volatility.
If a 5 doctor group adds a 6th partner in two years, and a 7th partner in 3 years would that be a “legitimate business reason” or a “change in ownership” that allows us to shut the cash balance plan down?
Again, there is a difference between shutting the plan down and not restarting (which can be done after 4 years), and restarting it. While it may be a legitimate reason eventually if the size of the group doubles, we are still taking 7-10 years out. The actuaries would determine whether the plan can be restarted, not the group.
Legitimate reasons to close a plan is nebulous so I’m not sure anyone knows for sure what reasons are okay or not. I’ve never seen an IRS published list.
While that’s true, it’s all about minimizing risk. If an actuarial firm has thousands of plans and they are consistent in how they approach it, they would know. There are also ERISA attorney opinions on these matters that are not necessarily published, but any good actuarial firm will have access to this. And worst case, they can always consult an ERISA attorney on a case by case basis. So when it comes down to practical applications, there are very specific reasons that actuaries use, combined with other facts and circumstances to make these decisions on a consistent basis.
Kon, do you ever buy a certificate of deposit for a cash balance plan? Why or why not?
No. Here are several issues:
1) CDs you buy online are not the same as bank CDs you can get as an individual at your local bank. You can’t own these in a retirement plan account or a brokerage. They are CDs sold on the open market. While they are FDIC insured, you can’t just redeem them for loss of some interest. You will have to buy and sell them on an open market, and this can incur losses unless held to maturity. So from that standpoint, FDIC insurance is not very helpful. These CDs are basically just like other individual bonds, and such investments are not recommended for a CB plan.
2) CB plans are terminated often earlier than 10 year mark, so having individual bonds/CDs is not a good idea because they would potentially have to be sold at a loss when the plan is terminated, the longer maturity – the higher the potential loss. Short maturity CDs/bonds are going to be a hassle to deal with due to constant redemption, so managing this type of portfolio is more trouble than it is worth. Large CB plans do have such investments, but they are managed by teams and have lots of assets. So you are better off just using bond funds vs. individual bonds/CDs.
The best approach is to match the yield to the crediting rate using the shortest maturity funds available. I prefer target duration funds as those are exactly what is needed to manage risk.