By Konstantin Litovsky, Guest Writer
As a small practice owner or a partner in a medical or dental practice, minimizing taxes and building your retirement savings are two of your biggest financial goals. Doctors and dentists often have significant student debt upon graduation, and they also may have a relatively short time horizon until retirement, with many opting to stop practicing in their late fifties and early sixties. So it is no surprise that saving more than what is typically recommended by financial experts is the only way that such early retirement can be accomplished. Even with a relatively modest lifestyle, those who retire early will need to accumulate a sizeable portfolio without much time to get this done. While it is important to set up various buckets (including after-tax, Roth and tax-deferred) and to fill them to capacity, doctors and dentists in the highest tax brackets will see the most benefit from maximizing the tax-deferred bucket first. A 401(k) with profit sharing is the best plan for those who have the time to build up savings. A defined benefit plan known as a Cash Balance plan can be opened in addition to your existing 401(k). Cash Balance plans helps boost your tax-deferred savings if you plan to retire in 10 years or less and you would like to catch up quickly. This type of plan can also increase tax-deferred savings if you are making a lot of money now but are not sure whether this will last over the long term.
Benefits of Cash Balance Plans
Let’s assume that Dr. Smith practices in California, and he is taxed at the 37% federal and 12.3% state brackets. For simplicity, let’s say that his highest tax bracket is 50% (in reality this number can be even higher due to other taxes imposed in CA on business entities). Let’s also assume that Dr. Smith will retire with an income of $200,000, so his highest brackets are 24% federal and 9.3% state, or 33.3% in total. Also, let’s say that all of this income will be withdrawn from Dr. Smith’s retirement plans. This is not recommended in practice – it is always better for someone in the highest brackets to generate as much income as possible using after-tax accounts, so this would be the worst-case scenario. We will also assume that Dr. Smith is withdrawing enough to cover RMDs (required minimum distributions) which start at age 72. For Dr. Smith, his effective tax rate in retirement is estimated to be 21%.
Because contributions to his tax-deferred retirement plans are made from the highest tax brackets and withdrawals are taxed at an average tax rate, the tax rate differential for Dr. Smith is 29%. So this is how much Dr. Smith saves by simply making contributions into his tax-deferred retirement plans. If Dr. Smith happens to retire in a state with no income tax, this tax differential can be even higher.
A 401(k) with profit sharing allows a maximum contribution of $55K in 2018 (or around $75K if the spouse works for the practice), but if you are firmly in the highest tax brackets, a Cash Balance with a maximum contribution that ranges from $100K for someone in their early forties to as much as $250K for someone in their sixties will allow high earning doctors and dentists to shelter more earnings from taxes in excess of what’s allowed by the 401(k) plan.
Cash Balance plans are IRS qualified plans that are a hybrid between a Defined Contribution plan and a Defined Benefit plan. In these plans, each participant has an account that grows annually in two ways: employer contribution and an interest crediting rate which is guaranteed. The employer specifies a contribution—usually based on a percentage of the employee’s earnings—and a rate of interest on that contribution that will provide a predetermined amount at retirement, usually in the form of a lump sum.
Unlike a traditional defined benefit plan where contributions to the plan are based on funding to a benefit at retirement, a cash balance plan uses a hypothetical accumulation account to track how much needs to be funded each year. Both plan types have the same ultimate maximum benefit and lump sum. The difference is simply whether the calculations are done based on a current lump sum or based on a benefit at retirement age. The maximum annual benefit each participant can receive at retirement is capped at $220,000 per year (for 2018). In a traditional defined benefit plan, the employer commits to achieving the goal through regular, annual contributions large enough to meet the goal. In a cash balance plan, various types of plan design formulas can be utilized to meet the needs of business owners with different financial timeframes, goals, and available cash.
How Much Can You Contribute to a Cash Balance Plan?
Age | 401(k) only | 401(k) with Profit Sharing | Cash Balance | Total (Maximum) |
56-62 | $25,000 | $62,000 | $211,000 – $259,000 | $273,000 – $321,000 |
50-55 | $25,000 | $62,000 | $142,000 – $197,000 | $204,000 – $259,000 |
45-49 | $19,000 | $56,000 | $104,000 – $133,000 | $160,000 – $189,000 |
40-44 | $19,000 | $56,000 | $77,000 – $98,000 | $133,000 – $154,000 |
35-39 | $19,000 | $56,000 | $58,000 – $73,000 | $114,000 – $129,000 |
30-34 | $19,000 | $56,000 | $44,000 – $55,000 | $100,000 – $111,000 |
Table 1. Typical 401(k) and Cash Balance contribution ranges (2019).
The maximum contribution to a plan depends on your age, ranging from $50K if you are in your thirties to $250K a year for someone in their early sixties. This cap makes Cash Balance plans ideal for high earners and for those who need to catch up on their retirement savings. Once you decide on how much you’d like to contribute, every year you’ll be given a range that depends on your prior contributions and investment return. So if you want to contribute $100K, you might be allowed a range from $80K to $120K. If you consistently contribute on the higher end of this range, your subsequent contributions would have to be lower than your target contribution ($100k). One important point to note is that you can’t change your target more than once in about 3-4 years – if you keep changing your target contribution level too often, the IRS could deem your plan a deferral plan subject to the 401(k) limits rather than a pension plan with the larger maximums.
If a company has employees other than owners, it will need to make contributions on behalf of staff to take advantage of the maximum available contribution. But this is usually more than made up for by the tax savings.
How Long Can a Plan Be Open?
For solo practices, these plans usually exist for a relatively short period (typically for 10 years or less). At maximum contribution, a plan would be ‘maxed out’ after 10 years. An owner/partner can no longer make contributions into a plan once they reach the lifetime maximum amount (currently around $2.8M at age 62 and adjusted annually for inflation). But with a group practice, this does not impact the other partners who can still make their own contributions independently. For group practices, Cash Balance plans can be adjusted indefinitely as new partners join the practice and older ones retire.
Cash Balance Maximum Contributions
There is a lifetime maximum that is indexed to inflation, and it is currently around $2.8M. However, this is the maximum that is reached only when one maximizes Cash Balance plan contribution from age 52 to age 62 or from age 57 to age 67 (between 62 and 67 retirement ages some rules apply, so the maximum is slightly lower). For a younger participant, the plan maximum can be significantly lower (~$1.4M for a 40-year-old). For a solo owner, once this maximum is reached, the plan is terminated, and the assets can be rolled over into an IRA or a 401(k) plan. If you are a participant in a group practice Cash Balance plan, you can still roll your money into an IRA or a 401(k) plan but only upon reaching the normal retirement age (typically 62), termination, or retirement. The plan can remain operational as long as there are other participants in the plan.
Plan Start Age | Lifetime Maximum (2018) |
35 | ~$1.2M |
45 | ~$1.95M |
55 | ~$2.6M |
Table 2. Maximum plan total contribution assuming a plan that is open for 10 years with maximum allowed annual contributions.
Who Is a Good Candidate for a Cash Balance Plan?
If you are a solo practice owner with staff, Cash Balance plans can make sense if you are 40 years or older with the ability to contribute at least $100K a year consistently on top of the 401(k) contributions. Younger solo owners with staff would most likely not benefit from a plan until they are older and/or their practice demographics makes them cost-effective. If you have no staff, Cash Balance plans can be a good choice when you are younger (as young as age 35). With a staff that is significantly older than you are, Cash Balance plans might not make sense until you are in your late 40s/early 50s. If you are part of a group practice, Cash Balance plans might work out even if some of the partners are very young (even as young as 30).
If you are a solo owner or a partner in a group practice without non-HCE staff, it is fairly easy to design a plan that would work for your specific situation. If your practice has sizeable staff, adding a plan can still be a good idea, provided a design study is done to ensure that the benefit justifies the cost. Typically, when a Cash Balance plan is added to an existing 401(k) plan with staff, the overall contribution for the partners goes up significantly. Thus, employer contributions to the staff are more than offset by higher partner contributions. In other words, the percentage of the overall contribution that goes to owners can be increased significantly with Cash Balanced plans compared to the percentage that goes to owners for only the 401(k) plan.
How Do Cash Balance Plans Work with a 401(k)?
A 401(k) plan typically has a match (or a non-elective contribution) and a profit-sharing contribution, and many 401(k) plans allow participants to contribute up to $55K maximum ($61K for those over 50) in 2018.
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 401(k) plan. However, if your plan is not covered by PBGC, the profit sharing contribution is limited to 6%, except when total employer contributions (401(k) 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.
If the practice has only partners, you have the most flexibility to set up a plan where each partner can choose how much they want to contribute. Partners who do not want to participate in a CB plan can instead max out their 401(k) plan. All partners can specify their contribution level into the CB plan up to the maximum allowed for their age.
If you have partners and non-HCE staff, your maximum contribution will also depend on your plan demographics, and it might not be possible to maximize your contribution because the required employer contribution for the staff can be significant. Typically a cross-tested plan design is used to make sure that the employer contribution is minimized.
Architecture and Cost
Because Cash Balance plans are intertwined with a 401(k), it is a good idea to have a single Third Party Administrator (TPA) administering both plans. Having two separate administrators creates too many logistical and administrative issues for the plan sponsor, especially if you are dealing with two large companies. If you’ve already established a 401(k) plan, the first step is to make sure that your existing TPA has the capability to handle and coordinate both plans, which may not necessarily be the case. Another alternative is to hire an independent actuary who can work with your existing TPA to provide you with plan design and administration services. There are a number of such specialty actuarial firms available that can provide ‘a la carte’ services to the TPA, and this way you can keep your existing TPA.
All of the money will be pooled in a single account, requiring the use of a record-keeper/custodian. Some custodians offer a trustee-directed brokerage account that is titled in the name of the plan. Even though such accounts are low cost, they are not the best solution. While there are many trustee-directed brokerage account providers, none offer adequate support or services necessary for a qualified retirement plan, especially if you have multiple plan participants. For that reason, it is recommended that you use a low-cost record-keeper with dedicated support versus simply a trustee-directed brokerage account.
An ERISA 3(38) fiduciary is typically retained to manage the cash balance plan portfolio. The plan portfolio should be designed based on the goals of the plan, and there should be a clear understanding of how this portfolio will address various risks to the practice (more on that below). When selecting your ERISA 3(38) fiduciary, always make sure that they have no conflicts of interest and favor low-cost index and passively managed funds, and most importantly, they should charge a fixed/flat fee (vs. an assets under management fee that is commonly charged by most advisors).
The cost of setting up a Cash Balance plan is usually on par with the cost of the 401(k) plan when all of the necessary service providers are included.
What Is a Crediting Rate and How Should It Be Set?
Crediting rate is the guaranteed return that all participants will receive. It is typically a number between 3% and 5%, and it is fixed for the duration of the plan’s operation. This does not mean that your plan has to have a return equal to the crediting rate though.
If your plan portfolio return is below the crediting rate, it can result in a plan that is underfunded. A return above the crediting rate results in a plan that is overfunded. At plan termination, your plan should be fully funded, so any shortfall has to be made up by the plan sponsor. Alternatively, if there is excess, any such amount would be subject to as much as 100% excise tax. So it is never advisable to manage the portfolio in such a way as to create significant under- and overfunding. If the plan is underfunded, the partners will have the ability to contribute more than their target, while an over-funded plan will result in lower contributions.
How Is the Plan Portfolio Managed?
While it is always better to have a higher return on your plan, even if you end up with a lower contribution as a result versus a lower return and a higher contribution, there are several reasons why having a volatile portfolio in a plan is a bad idea, especially for a group practice. For one, most plans will not be around for more than 10 years. This period is a relatively short horizon, so positioning the plan portfolio to achieve a higher return is one thing, but actually achieving a higher return is something else entirely if your portfolio is volatile. Group practice plans might be around significantly longer than 10 years. However, they are still subject to certain risks that can result in early termination and asset liquidation under less than ideal conditions. Here are some of the risks these plans face:
- Changes in the medical field that result in one of the following: the practice is absorbed by a hospital, merges with another group, or dissolves entirely, which can lead to plan termination and the sale of assets under potentially unfavorable conditions.
- Market crashes and prolonged recessions. If a significant portion of plan assets is invested in high-risk assets that can lose value, partners might have to make a higher contribution than they planned into the plan. And when the sale of plan assets is required in the case of large distributions or plan liquidation, this can lead to significant losses that must be made up by the partners. When older partners retire early and/or take lump-sum distributions at retirement, large distributions from the plan would be necessary, and this will require the sale of plan assets under potentially unfavorable conditions. Retiring partners will get their full pension plan amount. But if the portfolio is too volatile, this volatility can result in other partners having to make up for plan losses if significant assets are taken out of the plan after a market crash.
- Not enough return or too much return. If there is not enough return, the plan is underfunded, and the partners will have to make extra contributions to the plan. If there is too much return, the plan is overfunded, and partners won’t be able to make desired contributions going forward. Also, at plan termination, any excess amount over full funding will be taxed at nearly 100%.
Even though higher return is preferable to lower return, higher return necessarily comes with higher risk that can expose the plan to potential losses under scenarios mentioned above. These potential losses can result in a lower return than expected, especially given the relatively short time horizon. Therefore, a low volatility portfolio is preferable, even if expected return will be lower.
While a Cash Balance plan portfolio will be rather conservative in most cases (especially for smaller solo and group plans), this shouldn’t be a deterrent to opening one. Compared with after-tax investing, even with a significantly lower return, Cash Balance plans would still be a better choice for nearly everyone in the higher tax brackets. Each partner will have the ability to adjust their individual 401(k) plan allocations, so they can always make their 401(k) allocation very aggressive and use their plan allocation as the fixed income part of their overall portfolio. It is better to make asset allocation adjustments on an individual level than on the plan level, especially when such decisions affect everyone in the plan.
Is a Cash Balance Plan the Best Fit for Your Medical Practice?
Here is a set of questions to ask before considering one of these plans:
- Are most of the partners maximizing their 401(k) plan contributions? If the answer is no, then a plan may not work unless a critical mass of partners has an interest in making contributions in excess of the 401(k) maximum.
- Are the practice demographics favorable to adopting a Cash Balance plan? For a solo practice owner or a small group practice, demographics can make a big difference. While for a larger group practice, demographics play a lesser role.
- Is the idea to have a plan for as long as the practice exists (which can be decades for a larger group practice), or will the plan be open for a specific amount of time? The goal should always be to run the plan as long as possible to minimize cost and paperwork. However, there are cases when a plan can exist for a relatively short period of time. In such a case, it is even more important to get all of the details right.
Before opening a plan, you will need to get an accurate illustration that will show how much each partner can contribute (and partners should be able to specify their contribution amount on an individual basis) as well as the cost of employer contribution to the staff (if any).
2018 Tax Law Changes
The 2018 tax law, in addition to new tax brackets, added a 20% income tax deduction on qualified business income (QBID). Unfortunately, service businesses did not get an unlimited deduction. So any deduction is phased out completely after a joint income of $415K is reached. However, any joint income in the $315K to $415K range is still eligible for partial deduction. While the rules of QBID are rather involved, this presents an additional tax planning opportunity for those who can get their income to fall into the above-mentioned range. The qualified business income subject to the 20% deduction would be S-corporation distributions or self-employment/K1 income (subject to W2 limitations when in the phase-out range).
As an example, assume that you are a married doctor with a stay at home spouse, your net is $500K, and you are 45 years old. With just a 401(k) plan, you can contribute $55K (in 2018), so this will not get you into the necessary range. However, with a Cash Balance plan, you can contribute about $150K into both plans, and this will cut your net income from $500K down to $350K. If your W-2 is $250K and your distribution is $250K, you can contribute enough to the combo plan to take a partial tax deduction on your distribution. With K-1 and self-employment income, things get more complex in the phase-out range, but it is still doable to structure your income in such a way as to take a partial deduction.
If you have a solo practice and your income is above $500K, these plans might not help lower your income to get a partial deduction, especially if your spouse works as well. However, if you are part of a group practice, a plan might be helpful to at least some of the partners in the group as they can use it to lower their net income to get a partial deduction. The other partners might simply benefit from having a larger tax deduction that a plan will provide. At this point, there are still many unanswered questions about the new tax law, so you should talk with your CPA regarding your specific situation to see how the QBID deduction applies to you.
Takeaways
- With contributions that are significantly higher than those allowed by 401(k) plans, Cash Balance plans can be a great way to minimize your tax liability and to save for retirement.
- Adding a plan to an existing 401(k) plan can be a good idea, provided the cost justifies the benefit. In most cases, adding a plan will be more than worth it for the practice, but proper analysis has to be done to make sure that is the case.
- When selecting your service providers, always make sure that they are working in your best interest, and that they will actually provide you with good advice and ongoing services to manage both of your 401(k) and Cash Balance plans prudently and cost-effectively.
[Editor’s Note: Konstantin Litovsky is the founder of Litovsky Asset Management, a wealth management firm that offers flat-fee retirement plan advisory and investment management services to solo and group medical and dental practices. Konstantin specializes in setting up and managing retirement plans and serves in an ERISA 3(38) fiduciary capacity Litovsky Asset Management is a paid advertiser and a WCI Recommended Practice Retirement Plan Provider, however, this is not a sponsored post. This article was submitted and approved according to our Guest Post Policy.]
Are you an owner that has implemented a cash balance plan for your practice? What type of practices do you think would benefit most from these plans? Have you been a participant? Would you recommend it to others? Comment below!
When I first heard of the cash balance plan I really wanted to incorporate that into my current practice.
Unfortunately it was deemed financially not worth it because of our practice size (particularly the number of non-physician employees (we have around 70 physicians and close to 500 employees in our group practice).
As I was maxing out my retirement contributions I thought this would be a good way to get more in (however a lot of my partners were not maxing out their current retirement options also making a cash balance plan not the best overall for the group).
For those that it does apply to it definitely seems like a great way to stockpile more retirement money than the traditional way of doing it.
So even with this type of ratio is it always worth trying to do a design study. If you are doing PS, adding a CB is an easy choice, but if not doing any PS, CB can definitely get costly. However, a good actuary should be able to do a comprehensive design study, and the cost might not be as bad considering the benefit (provided enough docs actually want to use a CB plan). The good thing is that a CB plan is a lot more restrictive than a 401k plan, so even if PS does not work, CB can work quite well.
Exactly. In my partnership I think less than 10% were maxing out the DBP, and the limit at that time was only $30K. Most were putting in the minimum required, which was like $2250. I assure you this isn’t a concern for most docs because they aren’t even maxing out the individual 401(k)/PSP that is usually associated (and cheaper than) a DBP.
Does anyone have numbers on what percentage of physician practices offer cash balance plans? It’s certainly not something that I am terribly familiar with, but it sounds like a great way to shelter more money.
If the recommendation is to make sure a large portion are maxing out their 401K first, I wonder how many practices do this – given the low financial literacy seen in a lot physicians. (I am sure that the groups that “get it” educate their incoming partners, though).
Also, you mentioned that the money couldn’t be accessed until age 62, termination, or retirement. Is that retirement at any age? If you have a young partner who does well, contributes to the cash balance plan, and retires at age 50… could they access the plan at that time? Would that require the other partners to contribute more for someone who retired early?
TPP
I don’t think I’ve seen any numbers on that, but I bet that out of all of the CB plans out there, physicians probably lead the way (with dentists coming close second).
Many physicians (especially those working in larger groups) are aware of CB plans. However, they definitely need help in making sure that CB plan is actually a good idea for their specific practice (and also with the CB implementation). So this is the reason for writing such a long article – I really wanted to put down on paper as much as I could so that a typical physician/partner can understand what these plans are about before trying to see whether they can use one themselves. Things definitely get really complex with larger groups so a lot more care is needed (especially if the group has a big NHCE staff).
No, you can’t access the money at a younger age unless one of several things happens:
1) You change jobs and take the money out into an IRA/401k
2) The plan is terminated and possibly restarted again (I don’t recommend this strategy as it has pitfalls, including significant cost incurred).
Typically normal retirement age is 62, so that’s when you can do an in-service withdrawal. That’s not an issue at all, just treat this money as your bond allocation. If you’ve maxed out your own contribution, you are done. Over time you might be allowed more smaller contributions (if you max one out really early), but other partners don’t have to contribute to those who retire early.
I’ve spent over two years researching and reading about CBPs, and as always, the WCI (and this post in particular) are the very best resource out there.
I would appreciate your further expanding on this issue: “2) The plan is terminated and possibly restarted again (I don’t recommend this strategy as it has pitfalls, including significant cost incurred).”
I am a partner in a relatively small group practice with no employees. Our partnership is comprised of physicians ranging form the age of 40 to 65. For the various risks to the group that you so well detailed, and because we have had some negative changes in our revenues (and could easily have further changes in our income and even stability over the coming years) we have considered terminating our CBP early (perhaps around year 5), and then possibly restarting a CBP after a year or so. Would greatly appreciate your thoughts on this and elaborating on the pitfalls and pros and cons of termination and restarting.
To address your concern, you can simply implement a formula that decreases your contribution when your income decreases, it is that easy. If portfolio is invested conservatively, and the funding formula is picked appropriately, you don’t need to terminate the plan.
Thank you. Let’s suppose that because of poor prior advice, the fund was NOT conservatively formulated and is either currently underfunded or is at imminent risk of being underfunded with further market downturns, one or more senior partners are at the verge of retirement, and the practice is at possible risk of dissolving in the coming years (due to absorption by a hospital etc.). Essentially, lets suppose the perfect storm, where the majority of the partners and the group as a whole find it potentially advantageous to close the plan so each individual’s money can be rolled into an individual IRA. A year after, the group decides that the threat of group dissolution has passed, and it may now make sense to reopen another group CBP to maximize lifetime contributions. Is it possible? Pros and cons?
Too many variables to consider. I would consider each variable separately, look at the timing, costs involved, and make a decision based on facts that take into account the entire picture. Without a complete analysis this is just guesswork. Your formula can be amended, your portfolio can be realigned without having to terminate. But if you have specific actionable facts that can influence this decision one way or another, that’s a whole other matter.
What happens in the case of a plan being under-funded while a younger partner (50’s) is departing the group for a reason other than early retirement, say termination for any cause, disability, or relocating to a new job. Can the departing MD roll over her CBP funds into an IRA in that situation without the rest of the partners making up the shortfall? If not, what happens to her funds?
Also, I’ve read conflicting numbers for the full retirement age pertaining to the CBP. Is it 62 or 59 and 1/2?
Sleep Doc wrote: “Can the departing MD roll over her CBP funds into an IRA in that situation without the rest of the partners making up the shortfall?”
No. The CBP has to be well enough funded before the departing MD rolls over her CBP funds into an IRA.
Sleep Doc wrote: “If not, what happens to her funds?”
Her funds have to stay in the CBP until the CBP is funded well enough. Either the plan assets need to increase in value through investment return or more money needs to be contributed to the CBP to improve the plan’s funded percentage.
Sleep Doc wrote: “Also, I’ve read conflicting numbers for the full retirement age pertaining to the CBP. Is it 62 or 59 and 1/2?”
The earliest full retirement age in a CBP is 62. However, if a doctor terminates before age 62 and the plan is funded well enough, the terminating doctor can roll over her money from the CBP to an IRA and then distribute it from the IRA as she sees fit.
A group practice CB plan should never be underfunded. It is easy enough to make sure that it is fully funded each year. This means that there are issues with this plan that should be addressed before they become a problem for everyone.
The bigger problem when someone retires early and the plan is still in place is when the market crashes. The current partners have to make up for any shortfalls for the retired partner. For this reason, the plans don’t tend to last long term. They tend to get closed at least once a decade and rolled into 401(k)s or IRAs.
TPP wrote: “If you have a young partner who does well, contributes to the cash balance plan, and retires at age 50… could they access the plan at that time?”
In this case, “retirement at age 50” is the same as terminating employment, so the retiring partner would be able to rollover their Cash Balance Plan account balance to their Traditional IRA. Note the CBP has to be well funded enough (110% on a HATFA basis) in order for the retiring partner to rollover his money.
TPP wrote: “Would that require the other partners to contribute more for someone who retired early?”
As I mentioned above, the CBP has to be in a well-funded position in order for the retiring partner to receive his or her rollover. The other partners are not required to contribute more to get the plan to the required funded percentage. This can get uncomfortable, as the retiring partner is at the mercy of how well funded the plan is before they can roll over their money. This gets back to the importance of what Kon was saying in his article about investing the CBP assets conservatively with the goal of minimizing the volatility of the returns.
I’m a solo practice hand surgeon and I have had a 401K + profit sharing and a cash balance plan for the past two years. Because we are a small practice and my wife is also an employee of the practice (administrator), we are able to save roughly double the limits that are discussed in the article above. I would encourage small group / solo practices to explore the option of employing their spouse if for no other reason to reap the tax benefits in 401k / cash balance plans. We plan to retire early, and filling our “tax deferred buckets” very quickly with the combo of the 401k and cash balance plan has been extremely beneficial.
I’m a solo practice hand surgeon and I have had a 401K + profit sharing and a cash balance plan for the past two years. Because we are a small practice and my wife is also an employee of the practice (administrator), we are able to save roughly double the limits that are discussed in the article above. I would encourage small group / solo practices to explore the option of employing their spouse if for no other reason to reap the tax benefits in 401k / cash balance plans. We plan to retire early, and filling our “tax deferred buckets” very quickly with the combo of the 401k and cash balance plan has been extremely beneficial.
Yes indeed, but you have to be careful how much you pay your spouse. If the spouse is getting $250k W2 and her job is that of an administrator, that might not fly with the IRS in case of an audit, so you have to make sure that spousal compensation is done in accordance with the IRS rules/regulations. Last thing you want is a plan that’s unwound and contributions withdrawn, as well as owing all of the back taxes and penalties. These are complex enough plans that you don’t want to subject yourself to unnecessary risk just to get a higher contribution into the plan.
And of course always weigh that against the possible increased Social Security taxes that must be paid for the spouse. Remember also the spouse must actually do legitimate work and be paid a legitimate wage for it.
Question. I began contributing to my CB plan at age 40, and was quoted a lifetime cap of about 2.8M. I see you say that the limit is much lower for younger participants, perhaps around 1.5M. Is it possible our administrator misinformed me. I’m a little concerned because I’m contributing near max for my age. Our plan is quite aggressive with a 5% target interest credit and is invested 60/40 to obtain this long term (which it may not achieve).
Yes, the cap for a 40 year old contributing is much lower than $2.8M, that’s the peak contribution that you get if you start contributing in your 50s. So what they gave you is the highest possible contribution, not your specific maximum contribution, which is definitely lower.
I would worry about a plan with a 5% target that is trying to achieve it by taking huge risks. Once the interest rates rise higher, we might be able to get a 5% return from a 100% bond portfolio (we are already pretty close to that with a 3.25% 10 year Treasury yield). Taking such excessive risks is a really bad idea considering that the spread of returns for such a portfolio is simply staggering. That is, there is nearly zero probability of getting a 5% return, but you can have a wide range of returns that are all over the place, and for a plan that is at the imminent risk of closure year to year, that’s just a really bad idea to take so much risk.
TheGipper wrote: “Question. I began contributing to my CB plan at age 40, and was quoted a lifetime cap of about 2.8M. I see you say that the limit is much lower for younger participants, perhaps around 1.5M. Is it possible our administrator misinformed me.”
Your administrator is correct. Your lifetime cap in a Cash Balance Plan is $2.8 million, but the $2.8 million assumes you roll over the money at age 62.
The maximum lump sum is reduced by 5.5% for each year you receive the lump sum before age 62. For example, if you terminate your plan at age 55, then you multiply $2.8 million by (1.055^-7) to calculate your maximum lump sum at age 55. This equals approximately $1.92 million.
But beyond age 50 when he’ll presumably max out his CB plan if he contributes the most allowed, annual contribution will be extremely small, so from tax planning standpoint it is not even relevant. So the $2.8M is a very misleading number that is thrown out left and right by those trying to sell these plans to doctors/dentists without explaining the nuances, that in most cases if you max out your plan you won’t stay around to put away the full $2.8M, and in the rest of the cases you’ll simply have to terminate your plan to avoid paying admin fees and employer contribution while your contribution is next to nothing. That’s why I prefer to simply tell someone what their contribution would be at maximum allowed for 10 years, and this is a much more realistic number that makes sense from tax planning perspective as well.
Great post. I’m curious your thoughts on if this is beneficial as an independent contractor without any employees. The article seems to hint that this may be of benefit even for younger docs since there are no other employees.
Case in point:
Fresh out of training. Age 32. Approximate income is ~500k (or more with time). All of the money is 1099 income, entirely as an independent contractor. I already plan to max out 55k of solo 401k, Backdoor Roth x 2 (wife is currently stay at home), family HSA. Hoping to have additional funds to invest after that (hopefully a significant amount), although not yet sure how much that will be.
-If it doesn’t make sense now, at what age or income level do you think it would make sense.
Yes, you can get a personal defined benefit/cash balance plan. The older you are, the more you can put in it and thus the expenses per dollar invested are lower.
If all your debt is paid off and you’re already investing a substantial amount in taxable, it’s probably worth looking into. I know Schwab offers one bu there are others.
As a 32 year old, your CB lifetime contribution is around $1M. Your PS would be limited to 6%, so your net contribution into both plans might be around $97k or so vs. just $55k into a 401k plan. So an extra $42k. Usually I advise against doing this as a 32 year old, but in some cases it makes sense (especially if you know that you won’t have 1099 income for long, or you plan to join another practice or become an employee in a practice). You really need a very stable source of income for at least 4-5 years. When you move to another employer, you can have another CB plan that you can max out, so this is also a reason to open one as a 1099 contractor, as your lifetime maximum is per employer.
Now, if you are a part of a group practice, in that case you can definitely benefit as a 32 year old because you are not paying all of the costs for the plan vs. paying everything yourself for your own plan (this is why I typically recommend the threshold to be at least 3x just the 401k contribution before starting a CB plan, or a total of about $150k, which you obviously can’t do as a 32 year old).
Tell me more about the lifetime contribution limit. Is that per plan? If so, how would they know about another plan you have with an old employer or something. Is it reset if you roll the CB plan into a 401(k)? I thought it was just an actuarial figure that helped determine how much you can contribute in any given year
WCI wrote: “Tell me more about the lifetime contribution limit.”
The maximum lump sum a doctor can roll over from a Cash Balance Plan is $2.8 million at age 62. The $2.8 million lump sum is the lifetime benefit limit rather than the lifetime contribution limit. How much the doctor contributes in order to accumulate $2.8 million at age 62 heavily depends on the investment returns the doctor earns on the plan assets.
So what happens if you once had a CB plan and it has been closed and rolled over. What is my limit now if I start a new one? $2.8M or $2.8M minus the amount I rolled over when that plan closed?
$2.8M minus the amount you rolled over when that plan closed. However, if the closed plan and the new plan are not part of a controlled group, then you would be able to still accumulate $2.8M in the new plan.
If you’re an employee of an employer (NOT an owner) and the employer sponsors a Cash Balance Plan, the lump sum you receive when the plan terminates would not count against what you can receive from a Cash Balance Plan that you sponsor with a company/entity you own (i.e. WCI).
Take your case as an example. The CBP lump sum you rollover from the work you do as an ER doctor would not count against the lump sum you can receive if your WCI business sponsors a CBP. This is because the hospital and WCI do not form a controlled group and so the two plans have separate benefit limits.
So it’s $2.8M per employer then. Very nice.
Yes, but just be aware that it wont be a good idea to keep a plan open past your max-out age in most cases. At least this is what honest actuaries say who are not interested in just billing you for admin costs for a couple of decades without much benefit. Only if you have a group practice can you keep your individual account open as long as you keep working for them. In all other cases it makes sense to simply terminate the plan, and possibly re-starting it later.
Kon Litovsky wrote: “As a 32 year old, your CB lifetime contribution is around $1M.”
This is not true. Assume the 32-year old opens a Cash Balance Plan now and keeps it open until age 62. The 32-year old has the ability to roll over $2.8 million from the CBP when they turn 62 based on 2018 limits. The 32-year old just has longer (30 years in this example) to accumulate $2.8 million in the CBP in contributions and investment earnings.
If we also assume the 32-year old earns no investment returns during the 30 years the plan is in place (just for illustration purposes), then the 32-year old has to contribute all $2.8 million to get to the $2.8 million limit at age 62.
See my response to TheGipper regarding how the maximum lump sum is reduced based on the age the lump sum is rolled over.
Yes, keeps it until age 62. But that’s a big assumption. So for solo practice owners and individuals this is 100% not going to happen – they won’t pay the cost of a CB plan until age 62 just to put in inflation adjustments every year.
Things might be different for a group practice though, but again, that’s a big assumption. I tried to keep things simple here. One solution is to terminate the plan and open a new one later on and contribute the rest, but again, it all depends on amounts vs. the cost. You still have to make employer contributions, so for this reason keeping the plan open until age 62 is not a valid solution in majority of cases (thus I didn’t consider it).
I may have missed this but so does your 401k contribution (of say $55k) have to be subtracted from the cb contribution of $97k? And if so why?
I’m in a very similar situation so wondering what the costs of setting up the cb would be?
Kon, great article and great explanation! thank you
I can highly recommend a DBP for solo-practitioners. I started mine in 2010, fairly unusual at the time and it was also hard to find info online then, except for a very brief post on Bogleheads that got me started. Plenty of info now and advertisement by financial companies like Schwab. I used ML (had to explain to them wat an individual DBP was!) with Ascensus as record keepers but moved away due the ridiculous fees they were charging (AUM, funds etc., thanks again WCI for enlightening me) and moved to Vanguard (they needed to be taught too with te help of a TPA recommended by my accountant, but did well) . I contributed in the low six figures yearly, slowly creeping up, as well as to my 401k. As Kon has indicated also in previous posts (thanks), you have to be sure you have fairly secure income if you start a plan, you can’t just skip or underpay, you are committed for several years. I was 60% self employed, 40% W2 and left my W2 job this year. I decided to close my DBP 3 years early, funded 8 years) and continue to contribute to my solo-401 (eligible for up to 61k) if I want or I may start Roth conversions instead: I’m now eligible for the 20% tax deduction so great time. We are now FI, part-time life is great and I’m unlikely to go back to full-time, ever. Full retirement is more likely in the next 2-3 years, made possible due to the DBP.
Thanks for the insights. I was wondering does Vanguard provide full service for DBP including record keeping and actuary service? If not who did you use for those services. Thanks!
No, they don’t. It sounds like OP used a Vanguard trust account for the assets, and a TPA to administer the plan. This is the easiest way to do it for individuals (but it is not necessarily easy to do this as there are many moving parts). For group practices things are a lot more complex, so I use a specialty record-keeper and an actuary who is well-versed in plan design.
I wonder if this will be useful for a 59 year old woman self employed, contributiong max to sep ira
and earns $450 K -400K from practice ? Unsure of stability of income but suspect can earn $200-250K next 5-6 years, suggestions, also no employees currently should have new employee next year. Thank you.
Yes, this is exactly the type of plan that can work for someone in your situation. You can’t use it together with the SEP in the same year, so if you’ve made any SEP contributions for 2018, you can’t open one for 2018, only for 2019. If you haven’t made a SEP contribution for 2018, you can open a 401k and Cash Balance plans and make the contribution for 2018. It helps to have income stability, but if your income does fall it is not a big deal since the right contribution formula can be used to take that into account. As long as you can make a contribution of at least $150k into both 401k and CB, it is worth considering a CB plan, though I prefer that those who open CB plans should have the ability to max them out, as that would give you the biggest bang for the buck.
Kon Litovsky wrote: “You can’t use it together with the SEP in the same year, so if you’ve made any SEP contributions for 2018, you can’t open one for 2018, only for 2019.”
This might be true in her situation, but it might not be. Check out: https://www.irs.gov/retirement-plans/retirement-plans-faqs-regarding-seps-establish-a-sep
The specific Q&A is:
“If I have a SEP, can I also have other retirement plans?
You can maintain both a SEP and another plan. However, unless the other plan is also a SEP, you cannot use Form 5305-SEP; you must adopt either a prototype SEP or an individually designed SEP.”
Nena, do you know if you used a Form 5305-SEP to establish your SEP?
This is true, in most cases though the answer is no, but it is worth to check.
Most SEP IRAs opened through discount brokerages have their own SEP plan docs (Vanguard, Schwab, Fidelity, etc), so I’m yet to see someone using the form 5305-SEP used (never saw it in the last 5 years), but it is possible that some CPA might use one.
Suppose I’m a solo independent contractor and my CBP crediting rate is 4% but the plan only returns 3% this year due to very safe investments. Does this mean I am forced to make an additional 1% pretax contribution from my gross income? Or is the catch-up contribution taxable?
If it’s pretax, seems like a nice low-risk expansion of tax protected space.
Yes, you would need to make an extra contribution to make up for the shortfall (the actuary will calculate the exact amount year by year, but the impact would be minimal). Because most of the money goes to the owners/partners, even if you have to make a larger staff contribution, the impact would be small, so that’s also not an issue.Some docs worry about under-performing the crediting rate when that should be the least of their worries. Instead they should be worried of taking excessive risks in their CB plans, especially if those are group plans. If you want to take risks – increase your stock allocation in the 401k plan. Even if the under-performance is more than 1%, that’s also not a problem at all. As the interest rates increase, we expect bond prices to fall, but eventually the interest rates will stabilize and the bonds will once again yield around 4%-5%, so we can probably achieve 4% average return over the lifetime of the plan without any issues.
I wouldn’t be so sure that bond yields must rise. Perhaps they’ll muddle around where they’ve been the last year or two for decades a la Japan. Crystal ball so cloudy….
Rates are rising pretty steadily. From 1.4% to 3.2% and still going up. This is a result of a steady increase in interest rates, we can’t escape it. This is not to say that other things won’t influence the rate, such as huge stock market plunges (then the rate will fall). Or that the increase is one for one (it is anything but). But we know it will increase for at least a year or two more, thus we can nearly guarantee that it is going up one way or another (unless there is a huge recession/crash).
Imagine this recent stock market downturn turns into a 40% rout. You think rates will be higher in a year than they are now? I agree that they have gone up in the last 1-2 years. I disagree that anyone knows where they will be 2-5 years from now. Everybody has a guess and most of us are wrong.
By all means! If there is a huge recession/crash, all bets are off. I’m not trying to predict rates, just pointing out that short of a huge recession they are simply going to inch up as the fed rate goes up. Still preferable to hold the bonds vs. stocks in a CB plan, that’s the main point. If yields go down during a crash, but prices will shoot up, so you might have the opposite problem of bonds returning double digits 😉
Kon,
Thank you for the informative article. For clarification on one of the above questions- the extra contributions required for an underfunded plan would be pre-tax?
My group (7 physicians – all partners and no other staff) opened a CBP a couple years ago. Everyone is maxing out their CBP, 401K, and profit sharing plan. We set the crediting rate at 5%. The portfolio is 40% stocks (index funds) and 60% bond funds/CDs. It seems as though this is pretty aggressive for a CBP and risky to a small group. We have discussed this as a group and potential implications of a market crash combined with retirement of a partner or two. As of now we have determined that any partner that retires with underperforming CBP will compensate the remaining group members with forfeited salary to off set the required increased contributions the the remaining partners would have to make. Is this a scenario you have come across?
Hypothetically speaking, could you have a less volatile portfolio that would guarantee ~3% return (maybe CD ladders, other fixed income, etc) while keeping the 5% credit rating? You would surely have to make extra contributions to cover the 2% year over year shortfall. This seems like a backdoor way to increase your tax deferred contributions and eliminating volatility? Would this strategy be a red flag for an audit?
Yes, extra contribution is definitely pre-tax.
Yes, it is pretty aggressive in my opinion, and it definitely depends on specific security selection. You can have high risk bonds that act like stocks, so one would have to really dig into the allocation. Also, CDs are most likely no appropriate for this because of risk of early termination would require the sale of CDs at a loss.
I’ve never seen anything where partners are required to compensate the group when they retire. They don’t have to, and you can’t make them. This is wrong. I think that all the changes should be done at plan level to avoid having to do that in the first place, and the only way to do that would be to design an appropriate portfolio.
First, you don’t need to guarantee a return of any type. That’s a huge misunderstanding. Worst case is you need to put in a bit more money if you underperform the crediting rate. But that’s more preferable than unplanned market crashes for sure. On average with a bond portfolio you’ll get closer to 5% as interest rates stabilize. Not so with a stock portfolio. So better an occasional 2%-4% under, than 20-30% under when you least expect it.
No, this is actually not a reason for an audit at all. And this is the best strategy for a practice like yours to decrease your risk.
That’s why I advocate all-bond portfolios for smaller plans/groups where the plan is not guaranteed to last for many decades. Take the risk on the 401k side, it is really easy to do that on an individual level. That’s the problem with many advisory firms that provide investment management for group CB plans – they have no idea that they are not managing these portfolios correctly because many don’t have experience with CB plans and consider them to be the same as DB plans, which is not the case. Also, CB plans for small group practices are nothing like the same plans for huge law firms or a hospital, and have to be treated as if they can be terminated at any time. Thus the usual strategies are too risky for such plans.
So with the Federal Reserve planning on raising interest rates multiple times in the next year, it seems like a very bad time to invest in bonds and you very well may lose money. Would it not make more sense to ladder short term CDs (3-9 months ) and get your 2-2.5% guaranteed and then convert to bonds when interest rates stabilize?
That’s a good question, we were just discussing this with WCI, and as he says, we have no idea how bonds will actually perform with the rise of interest rates. In a CB plan, you always ladder, so that’s a given. A CB portfolio has to be designed to withstand interest rate increases (so for example there should be no long term bonds). As of today, the only way to get 2.5% in a CD is to buy one that’s around one year maturity. In CB plan accounts you don’t necessarily have access to a wide variety of bank CDs as you would if you went around shopping for one at an online bank. Also, as interest rates rise, your bonds will yield more and more, so this will potentially offset losses in principal over time. It is not as easy to manage a portfolio of CDs as it is to manage a portfolio of bond mutual funds. So for example, if prices fall, the following year you buy more of the same bonds at a lower price (dollar cost average) so there are definitely advantages to using bond funds vs. CDs. And ‘until rates stabilize’ involves a degree of market timing, and nobody I know possesses a crystal ball to be able to predict when exactly you are supposed to switch to bonds from CDs. It might seem like a simple exercise, but it is anything but. If you could predict that CDs will do better than bonds, then you can make a lot of money betting on the difference. Unfortunately it is not possible, thus you pick a strategy that works well in any market, and stick with it regardless of what the markets are doing. A laddered bond portfolio is one such strategy. Yes, you can lose some value when bond prices fall, but it can also generate more return than using CDs. Also, you want your CB plan investments to complement your 401k plan investments so when stocks fall, bonds should rise, thus I prefer using bond funds vs. individual bonds or CDs. But you definitely raise an interesting point.
One thing to note is that we don’t really care about guaranteed return, and this is not really a plan with hundreds of employees for whom you have to guarantee a benefit. Most CB plans are solo/small group practices, or partner-only practices, so as long as you get some rate of return with minimal volatility, it is acceptable.
Yes, that’s one cool feature I like about DB/CB Plans. People talk about it as a downside, but it really forces you to buy low!
Great overview and details of the plan.
The steady income needed is a big hurdle, with all the consolidation we have in medicine. But it’s a great tax shelter/arbitrage method for those in high tax states.
What are typical plan opening and yearly plan maintenance fees?
Do accrued amounts pass tax free to beneficiaries in the event of death of the plan participant?
I believe beneficiaries can get a distribution into an IRA just like with any other tax-deferred plans such as a 401k. Since the distributions are made as lump sums, this is not an issue at all (vs. annuities, where things get rather complex). For group practice plans this should be a no-brainer, but for solo practice with or without staff things do get complex, that’s why this is not a plan for everyone. Usually doctors have relatively steady income, unless you are a 1099 contractor, in which case you have to be careful about setting up a plan that you might not get to utilize long enough to make a meaningful contribution.
As far as costs, there is a relatively wide range in terms of what you’ll pay to set this up. Everything depends on whether your existing 401k provider can also administer CB plans or not, and what type of providers you are using, so each situation has to be examined separately. Obviously for group practice plans the costs are higher, but they are shared, so per participant it is probably the lowest cost.
There is one thing to remember with CB plans. You can make anywhere from 2x to 4x contribution into this plan, but the cost is about what you’d pay for the 401k plan in terms of administrative/advisory and employer contribution cost combined, and there are definitely ways to minimize overall cost by using an independent TPA/actuary, low cost record-keeper and a fixed-fee ERISA 3(38), so as long as AUM fees are minimized you can get a good plan cost-effectively. So from contribution vs. cost standpoint it is a lower cost plan than a 401k plan is, so I wouldn’t worry about the fixed cost (as long as it is reasonable) if your demographics is favorable so that your employer contribution cost is reasonable (as that’s probably the biggest cost component for practices with NHCEs). There is a larger termination cost for a CB plan than for a 401k plan, but again, the goal is to run the CB plan for as long as possible to get the maximum bang for the buck, so when everything is factored in, it is still the best plan out there. In some cases a CB plan would work when profit sharing might not. Every situation can be quite different, and should be analyzed on its own.
In my experience, the fees for a CB plan have been higher than for a 401(k)/PSP.
If you only look at admin fees, the admin fee is higher, but a record-keeper fee is much lower because it is a pooled account. However, for a SOLO DB plan, the fees are definitely higher. So it really depends on the number of participants and what’s included. I’m primarily talking about a small practice with staff or a small group practice.
Another assumption is that there are no AUM fees whatsoever, and that you are using the best/most competitive providers. So far I’m yet to see a CB plan that’s more expensive when a 401k plan when everything is included. Maybe the service providers I’m using are lower priced than average, so I guess that’s a good thing. I do see overpriced CB plans from time to time, but that’s just a result of the practice owners not doing their due diligence. But the worst offender is AUM fees. You can not have ANY AUM fees in a CB plan, period. Not for the custodian/record-keeper, not for ERISA 3(38).
Depends on the size of the practice. A solo plan could be as little as $1500 to set up and $1500 a year.
Thanks for the great article on a helpful topic. We discussed recently in a blogpost. I am planning on starting a solo CBP in 2020 using 1099 income, and I’ll be 52 at that time. Anticipate making 150K+ contributions steadily without difficulty.
Same question as Rogue One about start up and maintenance cost for a solo plan. Also what is the minimum numbers of years to keep this plan? I would guess target returns would be lower for a shorter plan say, 3-7 years
Also, I did not follow this example:
“As an example, assume that you are a married doctor with a stay at home spouse, your net is $500k, and you are 45 years old. With just a 401k plan, you can contribute $55k (in 2018), so this will not get you into the necessary range. However, with a Cash Balance plan, you can contribute about $150k into both plans, and this will cut your net income from $500k down to $350k. If your W2 is $250k and your distribution is $250k, you can contribute enough to the combo plan to take a partial tax deduction on your distribution. With K1 and self-employment income, things get more complex in the phase-out range, but it is still doable to structure your income in such a way as to take a partial deduction.”
How does the income go from 350K to 250K, and where is the distribution coming from? Also I assume an employed spouse would be subject age related contribution limits? Thanks very much.
I’ve actually published a comment replying to the question above, it is hopefully going to be posted soon.
So in that example the W2 is $250k, and distribution is $250k, and the CB contribution comes from the company money prior to the distribution, while salary deferral into the 401k comes from your W2. But the net effect is that if you can contribute $150k into both plans, your net income from the business is now $350k, so you are in partial deduction range. And of course if the spouse does work for you, there can be a bigger contribution into the plan and a bigger deduction, subject to age/income related limit with respect to both 401k and CB, but you still have $18.5k salary deferral, 3% non-elective match and 6% PS, as well as some amount of CB contribution, so this is usually worth it as far as getting a bigger tax deduction (especially if you can then qualify for another 20% deduction on pass-through income. So the 20% deduction (or partial deduction depending on where you are in the phaseout) would apply to all of the money that is distributed (after CB and 401k employer contributions are made). So in this case it would be around $100k or so assuming you’ve already paid all of the taxes. And this would be subject to a 20% deduction (or partial deduction).
In any case, this is a very crude example. Your retirement plan adviser would have to be working with your CPA so that they can analyze your specific situation in detail. These examples are extremely limited because they don’t include anything else (such as taxes, other deductions, etc).
The question above was not clear with regard to whether it is a solo plan for a single doc or a plan for a group practice, or a plan for a practice with staff. A solo plan also requires a TPA/actuary to administer, and total cost depends on whether you are using a custodian or a record-keeper for both accounts, and whether you are hiring an adviser to manage plan’s investments. So it all depends on the level of service that you need. Some docs use a low cost custodian (such as Vanguard) and manage the money themselves. Others prefer to hire advisers. Personally I prefer using a low cost record-keeper, not a custodian, and set up pooled 401k (for owner/spouse) and CB accounts with a record-keeper.
I’ve actually published a comment replying to the question above, it is hopefully going to be posted soon.
So in that example the W2 is $250k, and distribution is $250k, and the CB contribution comes from the company money prior to the distribution, while salary deferral into the 401k comes from your W2. But the net effect is that if you can contribute $150k into both plans, your net income from the business is now $350k, so you are in partial deduction range. And of course if the spouse does work for you, there can be a bigger contribution into the plan and a bigger deduction, subject to age/income related limit with respect to both 401k and CB, but you still have $18.5k salary deferral, 3% non-elective match and 6% PS, as well as some amount of CB contribution, so this is usually worth it as far as getting a bigger tax deduction (especially if you can then qualify for another 20% deduction on pass-through income. So the 20% deduction (or partial deduction depending on where you are in the phaseout) would apply to all of the money that is distributed (after CB and 401k employer contributions are made). So in this case it would be around $100k or so assuming you’ve already paid all of the taxes. And this would be subject to a 20% deduction (or partial deduction).
In any case, this is a very crude example. Your retirement plan adviser would have to be working with your CPA so that they can analyze your specific situation in detail. These examples are extremely limited because they don’t include anything else (such as taxes, other deductions, etc).
Thanks Kon, sorry if I was not clear. This is a solo plan for single doc using 1099 income. No staff other than spouse.
Vanguard does not handle solo CB plans, confirmed that with several calls. Thanks.
I keep posting long answers and they keep being either ‘moderated’ or just not show up. I contacted WCI, hopefully they’ll fix it. I’ll wait a day or two, my answers will eventually be posted 😉
Yea, the long ones tend to get held for unclear reasons. They apparently resemble all the long spam comments I get. Sorry! You’d hate to see what this comments section looks like if there were no spam filters.
In short, my answer to your post 11 above is the best I can do without more information about your specific needs. There are many different providers available, some include investment advice and some are just TPAs/actuaries. Vanguard is a custodian that some people use for the assets, but you do need a TPA/actuary in charge of this type of plan.
And your post was very clear, it was the post #10 where the size of the plan was not clear. Sorry about that.
And your post was very clear, it was the post #10 where the size of the plan was not clear. Sorry about that.
Great overview and I’m glad there’s more discussion about these plans now but I feel a misleading aspect (or one that isn’t regularly highlighted) are the maximum contributions for both a 401k/PS and DBP without factoring in the PS’ 6% of max compensation ($270k in 2017) or $16.2k. So a fairer max for a 401k/PS (would be $16.2k PS + $18.5K 401k) is closer to $34.7k vs $55k.
I’m aware of this now as I’m in the second year of my 401k/PS + DBP as a solo practitioner in my mid-30s but I wasn’t initially from my research as I merely assumed $55k from the 401k/PS plus ~$56k-$88k DBP as outlined in Table 1. I’m still satisfied with both plans as I’m exceeding the tax deferred savings of only a 401k/PS.
To share my experience with my DPB, I went with Schwab and they’ve set up a 25 year plan with a 4% target and projected retirement at 60 with estimated lump sum ~$2.4 million. My plan is projected to be fully funded by the 18th year (age 53) when it’ll either be rolled over into an IRA or 401k or I’ll have more years to contribute to the max dependent on returns. The average annual contribution is ~$65k.
Twenty five year? This is exactly what I’m talking about when discussing unscrupulous providers that simply want to bill you for setting up/managing this type of plan. There should never be a plan for solo practitioners that is run for longer than 10 years. There is no reason for it. You simply start a plan, run it for 10 years, then terminate when you max it out. If you end up with another plan later on, great, but this is what’s called malpractice by the financial industry. Schwab of course is nowhere near being a fiduciary, so they are happy to oblige.
And this is exactly a reason NOT to open a plan when you are in your 30s unless you really don’t see having 1099 income for longer than 10 years, in which case you just set up a plan for 10 years.
The 25 year plan is appropriate for a large group practice with multiple partners. Then it can be run for as long as needed. But for a solo, 25 years is just plain wrong. The whole point of setting up a CB plan is to max it out over 10 years, and avoid having to pay admin fees for lower contributions. I’ve specifically asked my actuary about this, and he would not set up plans like that because they benefit only one side – the service provider, who will bill you for 25 years instead of 10. Given the uncertainty in the medical field, you should put away the maximum possible right now, and later on before retirement you might also be able to open a CB plan again for a short period of time, instead of just dragging it out over 25 years.
It sounds like you have empmloyees, yes? Your contributions are far more limited in that situation than for an independent contractor doc or a big partnership of docs with few employees. I am able to put $55K into both my partnership 401(k)/PSP (the one with a DB/CB plan) and my WCI Solo 401(k).
Probably not because I don’t think Schwab does plans with employees (unless it is a spouse employee). Those are solo db plans.
It would be so much worse if he has employees. That’s the whole point. Just because you drag it out over 25 years does not make it worth it, in fact with employees it is even worse because you are still paying full employer contribution dragged out over 25 years and admin costs. This will most likely erase any benefit you get from getting a higher total contribution into the plan vs. just running the plan for 10 years and restarting it again. You are probably better off maxing out over 10 years, then opening it up when you are maybe 5 years to retirement and contributing the max again. You’ll definitely save a lot of money doing it this way, especially with staff. But I wouldn’t expect the likes of Schwab to offer a better solution to docs because they stand to benefit from doing these 25 year plans.
Even worse, with all of the changes in the medical field, how can someone commit to a 25 year CB plan? This is just ridiculous. Even 10 years is a tall order for many practices, as they have no idea whether they’ll be around in 10 years. But 25 years takes the cake. I always like to tell to our CB plan clients that a CB plan is a year by year plan. You never know whether you will terminate it or not the following year for whatever reason. Even a 401k plan can’t be guaranteed to work for that long, but a CB plan for a solo doc should not be assumed to last any longer than 10 years (and the assumption should be 5-10 years at the most). So if this plan actually terminates at a 10 year mark, he would not have maxed it out as he could have over 10 years, so there is a real risk of that as well.
I guess if the admin cost is bare minimum and there are no employees and nothing ever changes in 25 years that this can work out (vs. terminating and re-starting a plan, though I would still think the cost is going to be higher even with bare bottom admin fees), but I think this is also traded off against the fact that your PS is reduced to 6%, so that should also be taken into account, and even with termination and re-starting, this might add another $4k or so vs. the admin for an extra 10 years, so I still think that terminating and re-starting is a better approach however you slice it as it allows you to manage early termination risk better.
No, I don’t have any W2 employees as I’m a solo practitioner with no spouse. My main point was to raise the issue that when a DBP is paired with a 401k/PS that the contributions are limited to 6% of compensation which prevents the 401k/PS from reaching the commonly listed max of $55k. If someone can clarify how they reach $55k without an additional spousal/employer account, I’d greatly appreciate it. Here’s a nice overview on multiple plans and the limitations: https://definedbenefitplan.com/401k.html
In terms of the second issue of the long 25 year plan, I’m content with since it allows me to make larger tax deferred savings during my high earning years and also allowing career flexibility in my 50s. The fees are not exorbitant but I’m open to other opinions if they seem to be. The initial setup was $1,500 with an annual fee of $1,500 plus $750 for the separate 401k/PS which essentially is just the Form 5500 so $2,250 annually (18 yrs = $40.5k, 25 yrs = $56,250) for administration. There’s no AUM with the index investments carrying ER 0.03 to 0.06%. Plan termination will be ~$5-6k.
In conclusion, I’ve been a WCI disciple for many years and have been maxing out my “buckets” including a sizable taxable account so the DBP fee over a longer then normal horizon still works for me as I enjoy my practice/lifestyle so shutting up shop in ~10 years isn’t appealing. Although, I’m still curious about how to save more in these paired plans . Thanks again for all the insights.
I mentioned that in the article, if you have fewer than 25 participants you are limited to 6% (which is all solo plans, and most solo practice plans with staff, though there are some exceptions, specifically the 31% payroll). This is the relevant excerpt from above:
“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.”
This is just the law on the books, nothing more. There are some plan designs that can allow you to put away $55k in the CB plan with full PS, but those designs also limit your CB plan contribution, so the tradeoff isn’t worth it. You are just stuck with the 6% PS. For this reason I don’t think that 25 year plans are a good idea at all as discussed above.
Often, in pursuit of saving on admin costs, some docs end up hiring retirement plan mills, and as a result they don’t get the best possible plan design. For this reason I always advise to hire the best providers, not the cheapest ones, who actually are going to work in your best interest to avoid having sub-optimal plan design. As I discussed above, you will be limited to 6% PS, so instead it would have been much better to do a 10 year plan, and max out your 401k plan after the 10 year mark, and then possibly restart your CB plan later. If anything, you don’t have any career flexibility with this approach because if you decide to do something else you have to terminate the plan, so if you do this in 10 years, you won’t be able to max it out like you would if the plan was designed to be around for 10 years, as your contribution would be a lower with a 25 year plan.
What you are paying for admin fees is probably about average, so I would expect a little better service from your actuary. I wouldn’t necessarily change anything at this point, I would simply go back to the actuary and have them recalculate contributions so that you can close this plan in 10 years. But that’s really up to you and your adviser to decide whether this will work for you.
Sorry, I thought you were talking about 401(k) contributions. The 6% thing seems to be a defined benefit plan feature. You can max out an individual 401(k) ($55K) on less than $200K of income. That’s obviously far more than 6%. I always called the employer contribution “profit sharing” but perhaps that’s not the right terminology.
No, the 6% limitation applies to Profit Sharing of the 401k. See below.
https://definedbenefitplan.com/401k.html —-
“Can I add a Profit Sharing Plan and a 401k plan to a Defined Benefit Plan?
Yes potentially. When paired with a defined benefit plan the profit sharing contribution is limited to 6% of compensation. Profit sharing contributions are made by the corporation and are generally 100% tax deductible as a business expense.
The 2017 profit sharing limit is $16,200 which is based on the 2017 income limit of $270,000 X 6%. The 2017 IRS maximum compensation used to calculate defined benefit contributions is $270,000.
The 2018 profit sharing plan contribution limit is $16,500 based on the 2018 compensation limit of $275,000 X 6%. The 2018 IRS maximum compensation used to calculate defined benefit contributions is $275,000.”
Somebody better tell the folks running my PSP/401(k) for thousands of docs.
Seriously, there must be some different type of contribution besides a “profit-sharing” one that is letting us get to $55K in our 401(k). There’s no way thousands of docs are doing this wrong for years without anyone figuring it out.
It might be that our DBP contributions are pretty limited. Was $30K and now is only $50K. Dunno. But I’m having a hard time believing this is a hard and fast rule.
Yes, that’s PS limitation. When you have 25 or more participants you are not limited to 6%. So your plan can have $55k contribution. And if there is no NHCE staff, it is not a problem at all. You can do max PS and also max out CB plan contribution at the same time.
Your DB plan is not designed with a custom contribution for each individual doctor. This is really a bad idea, and the actuary you use is simply cutting corners. Each doc should be able to specify their level of contribution, and good actuarial firms can and should accommodate it. Without NHCes, it is not that hard.
There we go. That explains it.
We are allowed to choose our contribution from one of 4 or 5 levels I think. There’s a minimum of $2250 and I think the max is now $50K.
Yes, and that’s plain silly. Your provider is just not doing what they should be doing. The contribution level should be individually designed, from zero up to $300k or whatever the IRS maximum is. But I bet they are getting paid a lot more than an average provider, too. I remember they were charging you AUM fees for admin/record-keeping. Time to do some RFPs and unbundle everything. That’s the best way to have providers that actually do something vs. when everything is under one roof, and save money in the process.
BBGG, the annual admin fees you are paying to Schwab are reasonable. I would stick to your “25-year plan.” Yes, you will pay annual admin fees along the way, but you will also get the additional tax deductions. You will accumulate significant tax deferred assets following your plan.
One thing to consider doing is making “voluntary after-tax employee contributions” to your 401(k) Plan. You can then do an in-Plan Roth conversion on your after-tax contributions. It would be icing on the cake. Note your current 401(k) Adoption Agreement with Schwab may not let you do this. If a Third Party Administrator prepared your original 401(k) Adoption Agreement, you might just need to have them amend it.
Another thing you can consider doing is alternating how much you contribute to your Cash Balance Plan (CBP) in any given year. Here’s what I mean. In year 3 of the plan, limit your profit sharing (PS) contributions to 6% of your net pay and make the maximum deductible contribution to your CBP. This would lower the minimum required contribution amount in year 4. Then in year 4, you contribute less to the CBP and you max out your PS contributions. Note your PS and CBP contributions would just have to be less than 31% of your net compensation in year 4. Then in year 5 you go back to limiting your PS to 6% of your net pay and making a larger CBP contribution. And in year 6, it’s back to what you did in year 4.
I encourage you to take a look at your contribution range contained in the annual actuarial valuation report. Alternating your annual CBP contribution amounts should allow you to accumulate the same amount of money in the CBP in year 10, 15, or 25 of the plan AND contribute more PS along the way.
That’s interesting. That’s the first time I’ve heard of that strategy.
Just don’t do a 25 year plan in your 30s, that’s the best strategy. I bet the annual contributions are just a tiny bit more than just maxing out your 401k in the first place. Do a CB plan in your 40s and call it a day. A good actuary would never set something like this up.
BBGG did not commit to having a Cash Balance Plan (CBP) in place for 25 years. Chances are good that something will change between now and then and the CBP will need to be terminated.
If you are in your 30s and you want to contribute more than $55k per year (401k limit for 2018) on a tax deductible basis, a Cash Balance Plan (CBP) might be a great fit.
For those reading this, I encourage you to find out how much you can contribute to a CBP and how much it will cost in admin fees. You can then do the cost benefit analysis and decide if a CBP is a good strategy for you.
Question : to derisk your CB plan – if you move your equities from to CB plan to 401k or IRA by exchanging to bonds or money market in CB plan , does it make sense to transfer funds with losses and increasing your CB deductions ,
if you have no room in 401k- is it wise to move equities to taxable account , am not sure if it looks like tax loss harvesting or catching a falling knife? I have some VTIAX with losses .Thank you.
You can’t move equity mutual funds with a loss out of a CB plan then sell them in taxable and claim a loss. You can sell equities in the CB plan and buy them in a 401(k) or a taxable account, but the loss doesn’t transfer.
You never know if you’re “catching a falling knife” unless you know what the market will do AFTER you buy, and my crystal ball always seems to be so cloudy.
Loss does not transfer , but you still need to match crediting rate , so you can get business tax deduction and your asset allocation is the same?
You don’t need to match anything. That’s a misunderstanding. The key is getting a steady return with minimal volatility.
There is no way to move anything out of your CB plan until you are 62 unless you terminate the CB plan and restart it. And if you do an in-service transfer, you simply move your money out of CB to say your 401k, and you might even do so in-kind. What you might want to do if you take advantage of the in-service withdrawal at 62 is a Roth conversion. So if your equities fell say 50%, you do an in-service withdrawal, move to a traditional IRA (or a 401k), and then convert to Roth at the market bottom. With a Roth conversion you don’t have to sell the equities, as you can simply convert in-kind as well. So that would work. However, you would have to kick in quite a lot of money into a CB plan to make up for the losses (which might be a good tradeoff).
To de-risk a CB plan you really need to not have equities in it at all, but again the problem is selling equities at a loss to de-risk. Because your time horizon for the CB plan is really short, there is no room for selling equities to buy bonds, so your CB allocation should be all bonds at all times. Take the risk on the 401k side.
Has anyone heard of “market return” cash balance plans? How does it work? Any disadvantages over regular “fixed rate of return “ cbp? Thanks!
Yes. I would stay away from this approach. You are still at risk due to market losses and early plan termination, so everything I described in the article still applies. Your plan can still be underfunded and overfunded. Actuaries are not thrilled with this either, for obvious reasons as this makes their job more complex. This approach assumes that a CB plan is a ‘forever’ plan, which it is not. It is a year by year plan for doctors/dentists, unless you are a huge institution such as a big hospital/university. So in a ‘forever’ plan you would run a portfolio such as this, so that you could average things out over 7 years or what have you, but in a CB plan that only runs for 4-10 years in most cases this approach does not gain you anything.
Yes, I’ve got a brand new one this year. I’ll write a post about it when I understand what’s going on with it.
Hi, I’ve read this post and comments with great interest. Thank you all for posting your insights. Based on my understanding of a CB plan as described above, I plan to do the following… I will be a solo doc to begin with, and may eventually hire someone to work at a second practice location vs. have them remain as a 1099 employee.
I am 35, so my understanding is that I will have a relatively low ceiling for the amount I can contribute. Assuming I use some of the numbers listed in previous posts and I am able to contribute 100K per year for 10 years to the 1M maximum and close the plan out after a decade. I have the following questions
1) Can I roll this over into my 401K and then immediately open another CB plan?
2) Is there any sort of tax penalty associated with this?
If things pan out the way I would like, and the person who joins the second practice location ends up remaining and ultimately joining as a partner in the company, the following questions come to mind.
3) Would I be forced to include them in this CB plan? Or could they create their own?
4) If I am forced to include them, would we be forced to have the same contribution schedule/target closing amount of 1M?
Thank you for any insights you can provide to the above!
A 1099 is an independent contractor, not an employee. You have to follow the law in your state on whether you can pay someone with a 1099 or not. Your CPA should advise you on that. In some states it is OK, in other states you can be liable for penalties (and obviously if someone is a W2 vs. 1099, your retirement plan would have to be amended as well, which you will not like).
1) You can roll it into a 401k plan, but when you open the 2nd plan, your contribution will be negligible since you’ve already maxed it out after 10 years. In 20 years you might open another plan and you might contribute into that plan for several years, but unless it is a different practice that you are joining that has its own CB plan, you won’t be able to maintain a CB plan (unless of course you end up getting partners that want to keep this plan, for themselves).
2) No, but it will cost you, so if your contribution is not high (by that I mean inflation adjustment at most), then you won’t get any benefit out of it. If you max out a plan, you close it, and that’s it, unless other partners want to participate as well, in which case they can carry the costs associated with a CB plan.
3) If the associate is a 1099 contractor, they don’t have to be included, and neither would a W2 employee. However, that’s just the Cash Balance plan. The W2 employee would have to be included in your 401k plan.
4) If the doctor becomes a partner, they can choose whether to participate in both 401k/CB plans. They can put nothing or max out if they decide to do so. At that point it won’t be a ‘solo’ plan anymore, but that’s not an issue because if you use a TPA/actuary to create custom plan documents (which is typical with a Combo plan) that would be taken care of.
Wow, thank you for the prompt response.
Yes, I meant independent contractor. In one of my previous jobs, each physician was an independent contractor and I am envisioning keeping it this way at least to begin with until I am sure that the person plans to be around for awhile.
The last question is let’s say I open the CB plan, contribute 100K for 3 years, then something happens with respect to the work situation that I need to close it. Am I able to roll it into my 401K without any penalties since I technically terminated it early? Would there be some penalties (administrative, tax, or otherwise)?
Yes, you can roll it into a 401k plan, and 3 years is about the lower limit so if you don’t plan to have this plan around for at least 3 years, don’t do it. Or do it when you have more stability so that you don’t have to terminate it early. There is a termination cost associated with doing so, and while it is not huge, everything adds up, so the longer you can run this for, the better.
Thanks, I have every intention of keeping it longer. But want to know what I stand to lose if things don’t shake out the way I am hoping. Obviously without knowing all the details you can’t give a very specific estimate. But if I have 300K after 3 years, what size penalty might it be, like 5, 10, 15K?
Dale, in reading through this article and comments, you have learned about what a Cash Balance Plan can do for you. It might be easiest now to get on the phone with someone who can answer questions about your specific situation (contribution numbers based on your income, if there would there be a penalty if you had to shut down the plan after 3 years, etc.). It will likely take between a half hour and an hour and my guess is most retirement plan consultants won’t charge you anything for the call.
im still very confused. im 35 w-2 600k in private practice group of physicians 30 of us or so theres 3-6 up for retirement for the next 2-3 years. were on a 4% rate conservative setup. Im definitely one of the younger partners median age is probably 45-50. already maxing out 401 54k. plan has been going since 2011.
1. at my age does it make sense to contribute
2. there’s been talks of absorption by the hospital what happens then?
3. im not sure if i want to stay at this job regardless past 5 years what happens if i leave
4. this will take away from some of my real estate investment funds i was planning on doing this year does it make sense for me at this age
5. what kind of questions should i ask about it
1)You should contribute as much as possible given that the plan might not be around. You can participate in any number of CB plans (assuming each is for a different employer) over your lifetime, each with its own maximum, so with a net of $600k, participating in a CB plan is an easy choice.
2) If you are absorbed by a hospital, the plan terminates, and you roll it into a 401k plan, that’s all.
3) If you leave, you take a lump sum with you and roll it into an IRA/401k.
4) You should diversify. CB plan contribution for you will be relatively small. However, tax savings can be huge (which will depend on your marginal brackets, so the higher the brackets, the better the savings). So you need to consider your entire situation and decide what you should be doing.
should i be afraid that partners retiring will somehow make me have to pay their benefits? what happens if theres a sudden surge of retirements
also whats the max i can put in in a year?
If you are not a partner you have nothing to worry about. If you are a partner, you should probably talk to other partners about how well the plan is funded and how the portfolio is managed. Your maximum is determined by practice demographics, and only your actuary can tell you what it is. If it is just partners, then it is determined by your age. If there is NHCE staff, demographics has an influence over what that number is (usually it drags it down if demographics is not favorable). A 35 year old can put away about $70k, and if you are not limited by 6% PS, then you can also put away $56k into your 401k. If you are limited by 6%, your 401k PS is limited to just 6%, so your 401k total would be around $36k. Some plans have a design where you are only allowed to make a certain level of contribution vs. custom for each partner, so again, talk to your actuary and find out more.
Kon, I am currently 42 and employed by an S-corp (part owner). We might potentially be purchased by a larger practice in return for cash and stock in the purchasing firm. That firm is organized as an LLC, with 4-500 employees; the owners are not W2 employees, but describe themselves as “self-employed”, and I do not yet know anything further.
Under what circumstances would it be legal given this situation for me to open both solo 401k and cash balance plans? Would I have to be a 1099 independent contractor? Or would my potential status as a non-employee (buying 100% into the company health plan, paying SE tax and doing own tax withholding) allow me to do this? Are there rules about the what is offered to the actual employees that speak to what I can do? Also, assuming I can, does the fact I will only be working 2 years affect this decision (do DB plans have to stay open for a minimum time)?
You can’t use a solo 401k/personal DBP with employees that aren’t your minor children, and you can’t even do that with an S Corp. The plan you use has to be the same one you provide for your employees.
OK, but the S-corp will cease to be. Still, as an owner of an LC, even if you are not an employee of that LLC, you’re saying you can’t have these plans without covering the employees as well? This would seem to incentive me to take all cash in the sale and just be an independent contractor for the short period I will be involved with the new firm.
That’s right.
What plans are in place in the purchasing practice? If you are asking about what happens when you are bought out, it would depend 100% on what arrangement you have with the purchasing practice. It will have to be a controlled group one way or another regardless of your individual arrangement (LLC/S corp, etc), so the plan you can have will depend 100% on what they have available in the practice. So if they have a Safe Harbor 401k with PS, that’s what you can have. The owners can call themselves self-employed all they like, if they are opening all kinds of plans on the side and not including employees, they are breaking the law.
I would ask for the type of the plan they currently have, and that’s the plan you can join as an LLC/S corp (if that’s what you end up with). With so many employees you might not have any profit sharing at all, and you won’t have any possibility of doing any if that’s what their plan is like. But you basically would be joining their plan and abiding by their existing plan rules. I wouldn’t be surprised if they have a plan where everyone has their own self-directed brokerage accounts, if so, it can be a huge mess that I addressed here:
https://www.whitecoatinvestor.com/how-to-best-group-retirement-plan/
Thank you all for the wonderful information. I have a situation that is somewhat unique, which I do not believe has been discussed, and so wonder if someone could please give me some guidance that may help others as well. I live conservatively (not quite like a resident, but not like others attending physicians), max out all tax advantaged accounts and can comfortably max out my CBP plan figure below.
I am 40 years old and in a partnership with other physicians who are 63, 57 and 55 years old. We are looking to start a CBP with a 10-year horizon, after which the 57 and 55 year old docs retire, though the 62 year old will probably retire in approximately 5 years. A few questions if someone could be so kind:
1. Even though there is obviously a large discrepancy in age between myself and my partners, I should still contribute the maximum amount (I was told $145k) given the tax savings, correct?
2. In 10-years, the other two docs would have reached their maximum of $2.8M and so the plan will close. At that time, I would have 1.45M into it and can then open a new CBP with the employees that I will hire to replace the retiring docs? Or what would I do then?
3. Are there any downsides of the CBP to me in this situation given the age discrepancies?
4. What happens if/when the 62-year old retires in 5 years and the three of us are still in the CBP?
Any other advice or insight would be greatly appreciated. Thank you.
1) Sure, if there are no NHCE staff, you can contribute the maximum possible. With NHCE staff one would need an illustration to see how the numbers work out.
2) The plan does not close when docs max out. It doesn’t have to. Their individual accounts are ‘closed’ (in the sense that no more contributions by them will be made and they get their distributions). You don’t open a new plan, your existing plan will simply be redesigned every time there is a big change. This can be modeled by the way, so whoever is doing your illustrations should be able to tell you exactly what would happen once the older docs retire and you hire HCE employees.
3) Not at all, this is a perfect example of when a custom-designed plan would work quite well. No NHCE employees means the best possible scenario.
4) Nothing really, they will get their money and your plan will continue to operate until you terminate it, which can be when you max out and no more partners are joining the practice.
It seems to me that you need to spend some time with the actuary doing the illustration (and the adviser managing plan assets) and go over everything in detail. I wouldn’t recommend setting up a plan until have a full picture of what will happen going forward. You’ll need to possibly get illustrations showing what would happen when other partners retire and you hire employees.
Kon – thank you so much! Greatly appreciated.
Excellent article. Question: Could a 401k that is part of a paired-plan arrangement permit permit after-tax contributions that are immediately put into the Roth component of the 401k? Often referred to as a Mega Roth.
Thanks!
I think so, but a good question for a specialist as we’re getting pretty far into the weeds.
If it is a solo plan, then yes. If it is a plan with NHCE employees, then generally no. This is because after-tax can only be allowed if staff makes after-tax contributions, so in most cases this won’t work. However, you don’t need to do after-tax at all. If you want to maximize Roth, just do in-plan Roth conversion of tax-deferred contribution, the effect is identical and this does not require anything special other than addition of in-plan Roth ‘rollovers’ (as this is typically worded in the plan document).
Kon,
Thanks for that. Two questions:
1) So if Safe Harbor 401k, owners can max the AT contribution without other employees doing so?
2) I assume you serve businesses other than medical professionals. I have clients who would be interested and advising on these sorts of set-ups is not within my wheelhouse. I would note that most of my clients use self-directed IRA’s and 401k’s, including both Solo and Safe Harbor. Helping with self-directed rules and investing is something I do a lot with.
Yes, different level of profit sharing contribution, owner gets max, employees get whatever minimum is necessary to pass all tests. We always do an illustration to estimate what the employer contribution might be as we don’t want any surprises down the road.
Yes, we do work with successful startups, this can get tricky especially if a startup is growing, so we have to think ahead as to what type of plan to set up. They might be able to do some profit sharing at first, but if they grow very fast, this might not make sense over time as the staff grows. However, depending on the type of startup this might not be an issue, so each case has to be considered on its own. Some startups might be better off just doing SIMPLE IRAs until they get enough stability to warrant a 401k plan. Last thing we want is a plan that gets dissolved a year after it started because it does not fit the company’s financial needs.
Kon,
Excellent, thank you.
Can anyone tell me where they parked their dollars after max funding their cash balance plan? My actuary tells me I about to hit my limit of 2.8 Million.
How about a taxable investing account in index funds, muni bond funds, or equity real estate? Or spend it on something that will make you happier.
You can then go back to maxing out your 401k at $56k + $6k catch-up, and definitely after-tax. Your after-tax portfolio should be around the same size as your tax deferred (probably bigger) because this is the income producing portfolio that you will want to use before you tap any of the tax-deferred assets. Also, you will probably benefit from strategic Roth conversions in retirement, and paying taxes with after-tax money is the way to go (vs. selling your tax-deferred assets).
I don’t know that I ever really saw anything definitive on the catch-up contribution, whether that increased the $19K employee contribution AND the $56K total contribution or not. You seem to be implying it does both. Any good citation for that?
Yes, it is $19k plus catch up, and in addition to the $56k maximum:
https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-401k-and-profit-sharing-plan-contribution-limits
“$56,000 ($62,000 including catch-up contributions) for 2019; $55,000 ($61,000 including catch-up contributions) for 2018.”
Thanks.
I am 31 year old and will be finishing my training next year. I plan on joining a partnership (as a class B partner) straight out of training, and I will own my interest in the partnership as a California Professional Corporation taxed as an S-Corp. I plan to pay myself a salary of about $300,000 and a distribution of $200,000 per year.
My living costs are minimal and I would like to put away as much pre-tax dollars away as possible given my future marginal tax rate in CA of over 45%. Would it make sense to open a 401K/Cash Balance Plan? Ideally, I would like my 401K/Cash Balance Plan 100% invested in a low cost, domestic index fund and then rollover the Cash Balance Plan into a 401(k) every couple years. What are the annual costs associated with such a plan?
I am 31 years old and will be finishing my training next year. I plan on joining a partnership (as a class B partner) straight out of training, and I will own my interest in the partnership as a California Professional Corporation taxed as an S-Corp. I plan to pay myself a salary of about $300,000 and a distribution of $200,000 per year.
My living costs are minimal and I would like to put away as much pre-tax dollars away as possible given my future marginal tax rate in CA of over 45%. Would it make sense to open a 401K/Cash Balance Plan? Ideally, I would like my 401K/Cash Balance Plan 100% invested in a low cost, domestic index fund and then rollover the Cash Balance Plan into a 401(k) every couple years. What are the pitfalls and annual costs associated with such a plan?
The main issue you’re going to run into at 31 is you probably won’t be able to put much into a CB/DB plan due to age. At any rate, given that you will be a partner, you’re going to be limited to the plans the partnership puts in place.
Exactly what WCI said. It is not so much an issue with you not being able to contribute much, but you can only contribute into the plans that the partnership has established. It also depends on the size of the partnership. If you have enough partners, you can put the full $56k into the 401k plan AND also put in $36k into a CB plan for at total of $102k, which would be really nice, so in a group setting doing a CB plan contribution as a 31 year old is probably fine if your group is large enough (vs. doing is solo, in which case your total contribution would be only $82k due to 6% maximum profit sharing, though still not too bad considering that the costs will be split among partners).
You can not roll CB plan into a 401k plan every couple of years. You simply can not do that, and maybe you can do it once during the life of the plan after about 7-10 years or so, any more often than that is not possible due to IRS rules.
And by the way, if all of the partners are doing ‘solo’ plans in your group, they are breaking IRS/DOL rules for sure, so you want to establish a single plan for the whole practice that fits everyone’s needs, including a 401k and a CB plan.
Thank you so much for your response! Just to confirm, even if every partner in the general partnership owns their partnership interest through their own S-Corp, would it be against IRS rules for each member to set up their own “solo CB plan” at the level of their S-Corp? Or are they only allowed to set up a group CB plan at the level of the general partnership?
Thank you so much for your response! Just to confirm, even if every partner in the general partnership owns their partnership interest through an Professional Corporation (taxed as an S-Corp), would it be against IRS rules for each member to set up their own “solo CB plan” at the level of their professional corporation? Or are they only allowed to set up a group CB plan at the level of the general partnership?
The plan has to be set up for the partnership. Separate S corp is meaningless when it comes to retirement plans, as the partnership is the employer, not the S corp. So only a group plan would work. Not only would this be the right thing to do, it would be the most cost-effective thing to do as you will share in the cost of administration/advisory services, and the cost to individual partners would be minimal vs. having each one pay for their own plan. If you also have NHCE employees, it would be even more critical to set up a plan with a single record-keeper and an investment menu as they can’t be expected to set up their own plans.
Exactly. This is a common misunderstanding/mistake docs make. They open an LLC or corporation as their partnership entity and then think this entitles them to access to an individual 401(k) and DBP. It does not.
Thank you for the information! I think some of the partners may not know this and have been contributing to their own Solo 401(k)’s. Is this something that is fixable?
Yes, I talked directly with IRS about this exact issue several weeks ago. It is fixable, but it is preferable that it is fixed as soon as possible to avoid any potential issues down the line. IRS is more than open to help you fix it, and it might require a voluntary compliance filing (which is not a big deal since IRS specifically indicated that they are looking at this sympathetically vs. punitively, and as long as the proposed solution is adequate, they will just let the matter close). However, things change dramatically if you have any NHCE employees. In that case we would need to consider everything and figure out what has to be done to rectify the situation.
Thanks! I’ll be reaching out to your firm once I join the partnership
“You can not roll CB plan into a 401k plan every couple of years. You simply can not do that, and maybe you can do it once during the life of the plan after about 7-10 years or so, this is not possible due to IRS rules.”
I understand that its not common, but could you please elaborate on mechanisms by which rollover of the CBP funds into the partners’ 401k (or SEP IRA) COULD be done during the life span of the plan? My understanding is that per current IRS and legal precedents, such a CBP could be closed after x years with “legitimate” reasons documented (such as “employee dissatisfaction,” changes in the financial outlook of the company, etc.), the individual member’s funds distributed to their respective 401k or IRAs, and the plan again potentially re-opened at a later date? Would appreciate any/all thoughts or alternatives.
It is not that simple. You can close the plan maybe once after it has been around for maybe 7 years or so. That’s about it. No more closures would be available going forward for the same plan. So you only get one shot at it. This is what our actuary says, and he is the expert. There are very specific IRS rules that he referred to, and I can find out more, but this is it.
Not that there is a really good reason for closing a plan and restarting it often other than conservative investments, which only bothers maybe some docs who want to be 100% in stocks.
Businesses change and when they do, there are opportunities to close the plan. For example, our partnership was essentially ended, just two or three years (maybe four) after we had opened a new defined benefit plan, which was apparently a legit reason to end the second plan. We’re now on our third one in ten years.
The main benefit is lower fees and more control over investments, but there are costs to opening and closing the plan too. Yes, you have to have an IRS approved reason, but I think those are fairly common to come by/justify.
Yes, if the partnership terminates, that’s a legitimate reason, of course. But you can’t dissolve the partnership then restart it again as it was before, and do the same with the CB plan, that might be quite suspicious and probably not acceptable. And of course you can’t do it for the sole reason of restarting a CB plan, that would also be a really bad idea.