[Editor’s Note: The following is a guest post from Konstantin Litovsky, a blog advertiser and 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.]
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.
Why 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 Also, let’s say that all of this income will be withdrawn from Dr.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?
|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.
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 401k plan. If you are a participant in a group practice Cash Balance plan, you can still roll your money into an IRA or a 401k 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)|
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?
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 401k 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 401k 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 401k 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 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.
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 401k 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 advisers).
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:
1) 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.
2) 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.
3) 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 it the Best Fit For Your Medical Practice?
Here is a set of questions to ask before considering one of these plans:
1) 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.
2) 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.
3) 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 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.
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.
- 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.
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!