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 Also, let’s say that all of this income will be withdrawn from Dr.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!
Great discussion here. Is there any straightforward way to estimate corporate tax savings through the implementation of a CBP? For example if the corporation can defer 1M into a CBP how much could they estimate to save on corporate (s-corp) taxes? For partners who do not contribute to a CBP how do you recommend the costs of the plan be spread out as well as the “savings” from decreased corporate taxation?
Good question, I’m actually writing an article specifically on this topic (cost vs. benefit) where I will describe how one can calculate cost vs. benefit for using a tax-deferred retirement plan vs. simply investing after-tax . Your actual tax savings will depend on multiple factors and should be estimated on a case by case basis because your costs are also not the same as for other plans (and are billed differently). You are also talking about corporate taxes only (in which case you can deduct plan expenses on your return, especially if they are billed directly to the practice and not taken out of plan assets), but your actual tax savings on an individual level will also depend on the tax rate in retirement, which is something that is hard to predict (though we know that if you retire in a low tax state that your savings would be higher than if you retire in a high tax state). As far as partners who don’t contribute to a CB plan, if you don’t have NHCE staff, the costs should be shared only among the partners who are participating (deducted from their S corp income for example). If you have NHCE staff, it makes sense that only employer contribution to NHCE staff should be shared among all partners (as it is a benefit). In any case, each practice might have slightly different dynamics, so again this all has to be considered on a case by case basis.
S corp taxes are pass-thru, so there are no S corporate taxes. So if you’re all in the 37% bracket and a tax free state and contribute $1M, you’d save $370K total.
The cost of the plan is typically shared equally, but I suppose that is negotiable.
Thanks for both of your responses! Have read and reread this article and others and still trying to wrap my head around all the details. This helps clarify.
I am owner of a 6 physician practice and have had a cash balance plan in effect for 5 years and have accumulated 1.1 million in that account. I am turning 70 years old this year 2019. I want to continue to work and since I have not reached my maximum allowable contribution can I continue to contribute to the plan until I reach that total even though I will be required to take RMD’s from the plan?
I believe so. That’s certainly the way it works with 401(k)s so I assume DBPs are the same.
Are you sure you have to take the RMDs? You may not:
https://www.fool.com/retirement/2018/09/07/ask-a-fool-if-im-over-70-and-still-working-do-i-ne.aspx
Yes, you can continue contributing into your CB plan past 70 and 1/2. As far as RMDs, “If you’re still working at age 70 1/2, if you are still employed at age 70 1/2 and do not own 5% or more of the company you work for, then you can delay taking any withdrawals from your qualified plan or 403(b) until April 1 of the calendar year after the calendar year you retire. You must still calculate and take an annual RMD for other tax-deferred retirement accounts each year after you turn age 70½.”
So if you own more than 5% of the company, you have to take RMDs at 70 and 1/2.
Is it possible for physician group (14 equal partners and 1 employee partnership track physician) to have more than one cash balance plan? Seems redundant. However, plan that’s there right now that people seem to like has a maximum of under 40k contribution for regardless of age. Can we get another plan that allows more contributions? Or probably better just to revamp the plan we have?
I don’t believe you can have more than one CB plan for the same entity as you can with 401(k) plans. That said, you can have multiple CB plans, if one is for the main practice, and another one for you individually (or for another business you own or are a partner in). So these wouldn’t be two plans for the same entity but separate plans for different entities, as long as there is no controlled/affiliated group situation.
This type of design is something I see for group practices more often than I want to, but it makes no sense for a practice like yours – I call this lazy design. Your plan should have individually designed limits that are based on age, W2 and interest in participation (so those who want to max out should be allowed to do so). Your plan is just not designed properly can can be redesigned to fit the needs of all partners.
So yes, I would recommend overhauling your CB plan and possibly also looking at your 401k plan as well to make sure both plans are set up exactly the way the partners want, including design/optimal contributions, investment selection (adding low cost index funds), removing all AUM fees in favor of fixed/flat fees, and proper portfolio management for CB plan to make sure that it is not excessively risky.
No. But if you have multiple employers you could have multiple plans.
After reading the comments, I think I picked up on a couple items about CBP but want to clarify if possible. First, when the CBP is closed, are the assets able to be rolled over in kind to an IRA or 401k? If this is possible, then why would a very aggressive investor shy away from a high-equity portfolio? I understand the necessity of funding shortfalls, but can’t that flexibility be written into the plan if your income falls at the same time? Sounds like a potential loophole to me. I suppose if you get an overfunded plan, then you have to pay the tax man a bit more as you’re contributing less that year. However, that brings up my second question below.
Can a young doc manipulate the plan crediting rate such that he or she is able to contribute more to the plan more quickly than their actuarial computations say? For example, could a 32 year old in a high-paying specialty (in a theoretical 1 person CBP with 401k) set the crediting rate at 10% or even higher to put more money into an “underfunded” plan more quickly? Obviously, you’d have to be very confident in your job and earning potential stability, but the question is one of mechanics rather than principles.
Seems that if both of these are true, you could theoretically sock away a few million in equities while forcing yourself to buy them cheaply.
I don’t know if they can be transferred in kind, but I do know they usually aren’t. The reason to shy away from a high equity portfolio is simply that you may have to make large contributions to it in a market downturn. If you are not bothered by that and the plan allows it, go for it. I’m using the most aggressive portfolio my current CBP allows, but it’s only 60/40. No, I don’t think that flexibility can be written into the plan. If your income falls, you still have to make the contribution.
No, that’s the point of the actuarial computations. They determine how much you can contribute. I think the crediting rate has to be reasonable and I’m not sure you can say 10% is reasonable.
Lots of good questions to discuss. My comments below.
“After reading the comments, I think I picked up on a couple items about CBP but want to clarify if possible. First, when the CBP is closed, are the assets able to be rolled over in kind to an IRA or 401k? ”
Yes, it should be possible to roll the assets in-kind. I’m assuming the questions below pertain to a solo DB plan vs. a group plan (possibly with NHCE staff) that has different dynamics than a solo plan.
“If this is possible, then why would a very aggressive investor shy away from a high-equity portfolio? ”
If you are a solo DB plan owner, then you can have any portfolio you want. But if it is too aggressive, any gains beyond the crediting rate will be taxed at 100% by the government, so there is no incentive to have a high volatility portfolio in a CB plan.
“I understand the necessity of funding shortfalls, but can’t that flexibility be written into the plan if your income falls at the same time? Sounds like a potential loophole to me. ”
You can do exactly this and have income-contingent contributions. However, plans are designed to be maxed out over 10 years. You do not want big volatility of income for a CB plan. You want very high consistent income, otherwise CB plan probably makes no sense (or at least your income has to be on average high for it to make sense). You can have a plan last 20 if you want with low contributions, but it will be a waste of money since your annual contributions will be very low (and your PS will be limited in a 401k plan).
“I suppose if you get an overfunded plan, then you have to pay the tax man a bit more as you’re contributing less that year. However, that brings up my second question below.”
You would have to keep your plan open without any contributions to use up the overfunded amount, and that might take several years to use it up. Then you run into the lifetime maximum, so if your gains are too high you might have to keep the plan open for a while before you can close it (fully funded).
“Can a young doc manipulate the plan crediting rate such that he or she is able to contribute more to the plan more quickly than their actuarial computations say? For example, could a 32 year old in a high-paying specialty (in a theoretical 1 person CBP with 401k) set the crediting rate at 10% or even higher to put more money into an “underfunded” plan more quickly? Obviously, you’d have to be very confident in your job and earning potential stability, but the question is one of mechanics rather than principles.”
A 32 year old’s maximum contribution is tiny. If you overfund the plan via high investment returns and high contributions, it might take many years to use up the gains, and in the meanwhile you pay admin fees to run the plan, and your portfolio would have to return next to nothing in this time – not a good deal. That’s why maxing out over 10 and rolling over is a better, more consistent strategy.
You can overfund your plan in the first 5 years for example. But this simply means that you will contribute less in the subsequent 5 years. The total contribution amount is going to be identical one way or another. And with 10% crediting rate you won’t contribute much at all if you think about how these things work. Even if you did hit 10% return, it just means that your contributions will be rather low. On the other hand, low crediting rate allows for higher contributions. You can have a portfolio that returns 10%, but at some point if you have gains, you would have to reallocate to a low return portfolio. Too much of a timing game to get this to work. Of course, higher return is always better than a lower return, but again, if we can will ourselves a higher return over a short period of time, we could make a lot of money, period. But in reality this is not how things work out. This is why we hold over many decades, and CB plans aren’t the best vehicles for this type of long term investing.
“Seems that if both of these are true, you could theoretically sock away a few million in equities while forcing yourself to buy them cheaply.”
Not necessarily – you are assuming that you get a 10% or high return just because you are 100% in stocks. If/when you hit a recession, your high risk portfolio will lose 50%+, and this is the reason why CB plans do not like high volatility. They are designed to accumulate a certain amount of money over the shortest possible time period. The way to do it would be to contribute a fixed amount with an appropriate crediting rate set by the actuary. If you are lucky and the market cooperates, you can potentially get a higher return with a 100% stock portfolio, and thereafter not contribute much (while keeping the plan open), but that’s not a viable/repeatable strategy since 10 years is not a very long time. You might as well lose 50% in your portfolio at some point. Yes, you get to put that money in to make up for the shortfall, but that’s not the best strategy with CB plans, the amount of money you can put away is going to be fixed regardless.
And of course, the ability to terminate the plan when for example you are no longer a 1099 (or when your business gets absorbed/bought/sold/dissolved, etc), is important. If you are playing games with your CB Plan and any of the things I mentioned happen, you might not have the luxury of keeping the plan open for long, so you would have to make some uncomfortable decisions at that point. Take your risk in the 401k/taxable, etc., keep your CB plan invested safely and when terminated, move it to an IRA. No need to get creative given the risk/uncertainty.
Excellent article and comments. Many thanks to Kon, WCI, Jeremy, and all the posters. Would like to add a few other angles and questions.
Am a typical solo-owner/employee S-corp side gig that already has a solo401k trust plan with pre-tax, after-tax, and roth 401k accounts through mysolo401k (thanks, WCI!). Trust funds held at Fidelity. That 401k trust has its own EIN separate from the corporation. MBDR very important in my overall plan.
A) Am unclear on whether a new CB plan must be managed by the same entity running the solo401k. Is this 1) a requirement, 2) strongly suggested to avoid accidentally making a mistake like contributing >6% profit sharing to the 401k or 3) something that can be handled easily by a competent DIY’er? Mysolo401k definitely doesn’t handle CB plans, but frankly I’ve been quite happy with their services otherwise and don’t like to be disloyal.
B) In the same vein, do the CB plan and the 401k plan each have to have their own EIN and each have to have custodial funds held in completely separate accounts? For example, CB funds held by Vanguard as a custodian to keep them completely separate from solo401k accounts; or alternatively funds held with the same custodial, in different accounts, but linked on a login so all balances could be seen at the same time.
C) Does a form 5500 need to be filled out and submitted to the IRS only if funds within a SINGLE plan (solo401k being one, CB being the other) exceed 250K? Or if the either of the plans or their combined funds exceed 250K? And if it’s the combined funds, does a 5500 need to be filled out for both the solo401k and the CB plan, even if neither in isolation is greater than 250K? If the answer to the first question A) above is that you can have a separate manager for the CB plan and 401k, then I can absolutely see a situation in which miscommunication between both entities results in a failure to file a necessary form 5500. Am presuming – perhaps incorrectly – that this is one of the main reasons for wanting a single manager overseeing compliance for both the solo401k and CB plans (on top of the 6% PS limit). A competent DIY’er probably could just check the balances near the end of the year, make sure the combination isn’t >250K, and provide the relevant information to both the CB and solo401k plan managers, though again this adds a failure point that wouldn’t be present if it were all under one roof. First world problem, but a nice one to have.
D) If I’ve interpreted the prior comments correctly then it’s possible to set the contribution rate either as an absolute number or some relative percentage of an employee/owner’s compensation (w2 for s-corp). The latter would allow entities with a variable income stream the most flexibility so that you are not stuck in a situation where a low-revenue year “forces” you to make greater contributions than you could otherwise manage – am I interpreting that correctly? And if that’s true, are there generally accepted ranges for what percentage of compensation is allowable in calculating that year’s CB contribution? The QBI deduction has led to a lot of people trying to optimize W2/K1 splits in order to maximize the 20% deduction, but I can imagine some people would want a significant (near 100%) percentage of their W2 income to also be placed into a CB plan, presuming it doesn’t exceed IRS limits.
A) I don’t think it’s required. But coordination is important.
B) Don’t know.
C) Single one I think. The main reason for the coordination is to make sure you’re not overcontributing. Lots of people who start using a CB plan can no longer put $57K into the 401(k) for instance, even though the combined total is more than $57K.
D) Don’t know. The more I dive into the CB rabbit hole the less I know about Cash Balance plans. They’re complicated beasts.
“A) Am unclear on whether a new CB plan must be managed by the same entity running the solo401k. Is this 1) a requirement, 2) strongly suggested to avoid accidentally making a mistake like contributing >6% profit sharing to the 401k or 3) something that can be handled easily by a competent DIY’er? Mysolo401k definitely doesn’t handle CB plans, but frankly I’ve been quite happy with their services otherwise and don’t like to be disloyal.”
Not necessarily, but that would be a better idea. Whoever runs the CB plan has to have full control over the plan doc, so that entity should be managing both plans. Too many cooks, you know how that goes.
“B) In the same vein, do the CB plan and the 401k plan each have to have their own EIN and each have to have custodial funds held in completely separate accounts? For example, CB funds held by Vanguard as a custodian to keep them completely separate from solo401k accounts; or alternatively funds held with the same custodial, in different accounts, but linked on a login so all balances could be seen at the same time.”
Yes.
“C) Does a form 5500 need to be filled out and submitted to the IRS only if funds within a SINGLE plan (solo401k being one, CB being the other) exceed 250K? Or if the either of the plans or their combined funds exceed 250K? And if it’s the combined funds, does a 5500 need to be filled out for both the solo401k and the CB plan, even if neither in isolation is greater than 250K? If the answer to the first question A) above is that you can have a separate manager for the CB plan and 401k, then I can absolutely see a situation in which miscommunication between both entities results in a failure to file a necessary form 5500. Am presuming – perhaps incorrectly – that this is one of the main reasons for wanting a single manager overseeing compliance for both the solo401k and CB plans (on top of the 6% PS limit). A competent DIY’er probably could just check the balances near the end of the year, make sure the combination isn’t >250K, and provide the relevant information to both the CB and solo401k plan managers, though again this adds a failure point that wouldn’t be present if it were all under one roof. First world problem, but a nice one to have.”
Both. I would use a single entity to manage both plans and to file both forms for you. The cost might be a bit higher, but it is worth it.
“D) If I’ve interpreted the prior comments correctly then it’s possible to set the contribution rate either as an absolute number or some relative percentage of an employee/owner’s compensation (w2 for s-corp). The latter would allow entities with a variable income stream the most flexibility so that you are not stuck in a situation where a low-revenue year “forces” you to make greater contributions than you could otherwise manage – am I interpreting that correctly? And if that’s true, are there generally accepted ranges for what percentage of compensation is allowable in calculating that year’s CB contribution? The QBI deduction has led to a lot of people trying to optimize W2/K1 splits in order to maximize the 20% deduction, but I can imagine some people would want a significant (near 100%) percentage of their W2 income to also be placed into a CB plan, presuming it doesn’t exceed IRS limits.”
Yes. I don’t know all of the formulas actuaries use, but you can ask. I would also think that someone using a combo plan is going to be phased out of QBI completely or at least partially unless you are older. Don’t forget that it is not W2 income that goes into a CB plan but your company contribution. You can work out the best/optimal strategy with the actuary, they should be able to give you illustrations on what is possible with different W2s. Usually they expect 3 years of very high W2s if you want to contribute the maximum with a lower W2 later on.
Thanks very much, WCI and Kon.
Very informative as always.
Can also confirm that in doing some service vetting I’ve also been told the form 5500 would have to be filled out both on the CBP and 401k side, even if they are administered by separate TPAs. Certainly adding chefs there.
Late 2020, the in service distribution age was lowered to 59.5 yo. Now that I’m 57, I suddenly got really interested in the Cash Balance Plan at work when we make our 3 year election on how much to contribute to the CBP. So now you can make an election to contribute say 200K per year, drive your W2 earnings very low or low(er) tax bracket, do an in service distribution of say 100k (200k), what ever tax bracket you are willing to tolerate and rollover into a Roth IRA and repeat year after year with the pretax election to the CBP also lowering you tax liability on you conversion. And pay the taxes from your taxable account. Seems too good to be true. What am I missing in this analysis?? Just do this every year until I retire.
It lets you make an inservice distribution? A little unusual, but if you can get it, the rest sounds fine.
Provisions relating to plan amendments (SECURE Act, Section 601). This section of the SECURE Act provides relief from the anti-cutback rules of IRC Section 411(d)(6) for amendments to any retirement plan or annuity contract pursuant to any amendment made by the SECURE Act or pursuant to any Treasury or Department of Labor regulation under this Act. This relief generally extends to the last day of the first plan year beginning on or after January 1, 2022, or such later time as the Secretary of the Treasury shall provide, and extends to the last day of the first plan year beginning on or after January 1, 2024, for IRC Section 414(d) governmental plans and collectively bargained plans. In order to qualify for the relief, the plan or contract generally must be operated in accordance with the legislative or regulatory amendment between its effective date and the date the amendment to the plan or contract is adopted. (Added May 2020)
Reduction to minimum age for allowable in-service distributions (Bipartisan American Miners Act of 2019, Section 104). Prior to enactment of the Act, IRC Section 401(a)(36) provided that a pension plan does not fail to be qualified solely because the plan provides that a distribution may be made from the plan to an employee who has attained age 62 and who is not separated from employment at the time of the distribution. The Act lowers the minimum age for allowable in-service distributions under IRC Section 401(a)(36) from 62 to 59½. The amendments made by Section 104 apply to plan years beginning after December 31, 2019. (Added May 2020)
You can’t set your W2 very low, your contribution amount is based on W2. So if your W2 is very low, so is your maximum contribution. Also, you can move the money from CB plan to the Traditional IRA, not Roth IRA, so there would be an extra step to do it (Traditional to Roth). What you are suggesting is not the optimal approach. I wouldn’t do the Roth conversion until you are actually retired. Say your AGI is $600k. If you contribute to a CB plan, it drops to $400k. So far so good. But if you take a distribution, it becomes a taxable event, so your AGI is back to $600k. You are better off just waiting until your AGI is zero, and making the conversion then. You will save a lot of money on taxes this way.
I believe you may be referring to having your net W2 be lower after you’ve made the contribution as it is taken from your net earnings. Yes, that would be true, but we are still back to square one as far as your net AGI when you actually make the conversion. There is really no way to avoid this unless you are retired.
Well you could put say 200 in, take 100 out as an in-service distribution and still be down at least one tax bracket. The problem is if you wait to do the conversion at retirement, you might have $1 million in the cash balance plan and unless you have multiple years to do the conversion before your RMD begins at 72, you might run out of time if you were a mega saver. So you can start doing the conversions at 59 1/2 instead of 62 1/2 and gives you some extra time if you’re not planning to retire early. Or covert any other rollover IRA you might have. What about that idea?
Yes you could. That is still not optimal since you are still in the higher brackets. You might even have a lot more than $1M. You are most likely going to be better off converting all of this to Roth in retirement even if it puts you into higher brackets temporarily. However, to give yourself more time (say 10 years), it might make sense to start converting sooner, depending on when this conversion starts and when it ends (and it could be longer than 10 years), and what your total portfolio size is. Each scenario has to be run individually, there is no right answer for everyone. However, one thing is for sure – if your portfolio is not very large, you should convert when you have no income ($1M-$2M). If your portfolio is $3M or so, you still probably benefit to convert in retirement rather than when you work full time. For those with $5M-$10M, the math is a bit different, you end up in higher brackets when converting one way or another, so it might not be such a bad thing to start converting sooner, but also it does not make a big difference whether your conversion period is 5 years or 10 years once your portfolio is closer to $10M or so.
I hope some may still respond to this inquiry regarding CBP.
I’m a solo physician practice owner, age 47, with one full-time employee.
I currently have a SEP-IRA in the practice and am considering adding a CBP.
I am maxing the SEP-IRA annually and it is via Vanguard (i.e. no added fees).
Is it worth considering a CBP if:
1) if I would be contributing 50K or more to this annually
2) I understand this is not available via vanguard, so what is the best/cheapest way to start a CBP given we do not have a TPA for the SEP-IRA (I manage it directly)
3) other things to consider?
Thanks.
You’re going to need to get some professional help with this given your employee. I bet you switch into a 401(k) + DBP once a study of your practice is done, but you will almost surely need to put some money into the plan for your employee.
https://www.whitecoatinvestor.com/retirementaccounts/
Thanks for the reply. And yes, I figured I would do my best to estimate what those costs/changes might be before embarking on the switch – as trying to get a guestimate on the amount I would need to be able to contribute to reap the benefits of the switch, etc.
First, SEP can not work with a CB plan, you would need a 401k plan. Thus, if you decide to go the 401k + CB route, you will need a TPA/record-keeper, etc., to set this plan up, which adds cost, but if you can put away ~$200k into both plans, the cost usually justifies the benefit. One rule of thumb is that a CB plan only really makes sense for those who can max it out, meaning ~$140k at age 47, plus maximum 401k contribution (with PS potentially reduced to 6%, so the total might be around $38k or so). So if you only want to contribute $50k more, I would skip 401k + CB plan. With a SEP you are probably giving your employee 25% of W2, and with a 401k you might give them a lot less depending on their age relative to yours, but this is offset by higher cost of 401k vs. SEP, so in this case SEP might be a better option. I typically recommend CB plans only for those who are in the highest brackets, ideally 37%, and sometimes 35% (unless family AGI is high enough so that the spouse is making enough money allowing CB plan to be funded to the max).
Understand and appreciate the thorough response too!
I am in PP with a group of 17 docs, but we all have our own S-Corps. My S-Corp has no employees other than me and I have setup a CBP for it and have been contributing for 4-5 years now. I am interested in investing in land through the CBP; however, I don’t want to have to sell the land when I terminate the plan (which will likely happen in another 5 years). What are options for rolling that land into an IRA or 401k? Is that a possibility? I was told by my third party administrator that I can’t sell the land to myself at a loss through the CBP since I would be considered an interested party. Really, I don’t need to sell it for a loss or a gain, but I just want to keep the land and not have to unload it in 5 years when I terminate the plan. I’d appreciate any suggestions for options on this.
Oops. Just having an S Corp be the partner in your partnership does not give you the right to open your own retirement accounts instead of using the partnership retirement plans. You had best get some professional assistance at cleaning this up. I’d start with these folks: https://www.whitecoatinvestor.com/retirementaccounts/
Even if that weren’t an issue I would not put empty land in a retirement account. It’s very tax-efficient anyway since it has no income. Just own it in taxable. Sounds like even if you don’t own a big taxable account now you will soon when you clean up this retirement account mess you’ve made. Presumably the other 17 partners have the same problem.
Yes, if other partners have individual CB plans and the practice does not have a single plan in place, that’s a total mess for sure. They might have a single plan set up for the group, and individuals have separate accounts. I know this is a possibility, albeit a tricky one because each account has to be managed together with other accounts for reporting purposes so usually it is a lot less of an issue to have a single account set up for a partnership practice with no NHCEs. If there are NHCEs then only a single account would be acceptable.
And this is exactly why you do not allow individual doctors outside of the plan SDBAs for either a 401k or especially CB plan, without oversight. Precisely because they start getting advice from random sources that have no idea about ERISA or compliance. So a single error like that puts the whole plan in jeopardy because partners are collectively responsible even though the error is caused by one of them.
Thanks for the thoughts. We do not have a group retirement plan for our partnership as we are all independent contractors. Buying the land is not a as much a financial strategy for tax efficiency as it is just wanting a big plot of land for my boys to “play” on, but not wanting to take out a mortgage for it. I have a big chunk of money in my CBP that I don’t want to exceed 5-6% annual growth and land seems like a great opportunity for slow steady growth, but also something I could “use” with my young kids for hunting, fishing, camping, etc.
Are you getting paid as 1099 or K1? Is the partnership paying you? Or is an outside party paying each doctor separately?
We get a K1 but there is no group retirement plan. We all do that independently through our PAs/S-Corps.
Ok, so the partnership is the employer. These are just how the rules work. If partnership is the employer then here’s what happens:
1) If you want a 401k plan, you can technically set up your own individual solo 401k plans. This is technically allowed from prior discussions on this topic, but I would consult an ERISA attorney on this first. These are not considered to be ERISA plans (so they would be subject to some ERISA provisions and state rules). Probably a bad idea, but it can be done.
2) You have to set up a group CB plan for the group. No individual plans are allowed. You can technically still set up individual plan accounts, but again, this is just a lot of nonsense. Nobody understands these plans at the medical practice plan sponsor level, so this is going to be playing with fire and depending on the ability of your actuary to advise you, which I would never recommend.
As I mentioned before, at this point only an ERISA attorney can sort this out for the practice. If this was a scenario in front of me, I would immediately call an ERISA attorney and have them engage the plan sponsor directly. I would not be comfortable providing any advice until everything is sorted out.
I didn’t even know # 1 could be done. That’s news to me. Why would that be allowed? It basically lets the partnership hose its employees and just give benefits to the owners. That seems very much like the whole point of all the laws about the annual testing of retirement plans.
I agree an ERISA attorney should attend the next partnership meeting for this group. I don’t know what sorts of penalties they are facing, but I think they’re substantial. This is a big screw-up.
Not if they have employees! This is for partner-only run practices with no NHCEs. Like I said, this is borderline nonsense because in large practices this can turn into chaos. These plans have to ALL be coordinated with nearly identical plan documents, someone has to monitor all of this, etc., etc, so in practice it is very difficult to justify doing this due to complexity of the types of things that can be done (after-tax, Roth conversions, etc, etc). Just because it is possible does not mean it is recommended. That’s why I don’t write much about it – there is no need to give ideas to some of these practices where one or two docs don’t care if the whole practice is screwed just so that they can get their fix for buying bitcoin in a non-ERISA SDBA.
Just to clarify, the partnership pays our individual S Corps. Then our S Corps get the K1. So I have had a CBP in place through my S Corp for 5 years now.
Yes, that is correct. Partnership is the employer. Your entities form an affiliated service group. And I’m assuming you don’t have any NHCEs. This gets tricky, for sure, it is not a DIY space, and you can already see why. It is even trickier with partner-only practices from what I’ve learned over the years because you can bend the rules, but you probably don’t want to break them, because its easy to do so.
You don’t put real estate you plan to use in your retirement accounts.
I think this is a common mistake I see among physicians who are members of a partnership (receive a K1) and hold their partnership interest through an S-corp. They believe they can open a solo 401(k) or other individual retirement plan through under their S-corp rather than using the partnership 401(k). Any way you can write a blog post dispelling this myth with some citations? I’ve tried to convince some of my colleagues of this but it’s hard for me to find a reference online to prove it to them
No need to convince anyone. Just hire an ERISA attorney for a consultation, they’ll tell it like it is. No googling necessary. And in a profession where people make big money and also want to open retirement plans to contribute big money, that’s the least that they can do to ensure they are not a target for the IRS/DOL. This is like willfully cheating on personal taxes. Except that its a lot worse. IRS/DOL fines and penalties are very steep and a lot less forgiving due to the nature of these plans – plan sponsor is considered to be a sophisticated/institutional investor, so it is not an excuse that plan sponsors make huge errors that can cost them a lot of money to fix/undo. That’s the big reason why it is a good idea to have a TPA/actuary, an ERISA 3(38) fiduciary (who would be the first line of defense on these topics) and an ERISA attorney available to advise the plan sponsor.
First, you can not have a CB plan just for your entity as you form an ASG with other S corps, so unless you set up a single plan for the group you can not have an individual CB account set up. This wasn’t clear from your post.
Second, land is typically not an ERISA-approved investment, so that can’t be held in a CB plan, this would be an ERISA attorney question as it gets tricky:
https://perkinsaccounting.com/wp-content/uploads/2020/12/ebpaqc_pii_prohibited_transactions_primer_-Sept-2013.pdf
Not that you would want to have land in the first place as it has to be valued for retirement plan purposes, and it is complex/expensive to do that in the first place as this has to be done annually. You might end up with an overfunded plan when you have an investment that’s illiquid that you can’t control, so that’s a practical reason why you don’t do that.
Land is also most certainly not a 401k approved asset. I’m not sure who’s advising you, but at this point I’d talk to an ERISA attorney, first and foremost.