The single best tax break available to you is maximizing your retirement plan contributions. Most self-employed or partnered doctors already have a defined contribution/profit-sharing plan (SEP-IRA or 401K) available to them into which they can contribute $50K a year ($55K if you’re over 50.) If your federal and state marginal income tax rate is 40%, you just knocked $20K off your tax bill. But what if you want to save more of your money toward retirement? You can use a backdoor Roth IRA or even a taxable account, but neither of those reduces your tax bill this year. One option you should consider is using a cash balance plan.
A Hybrid Retirement Plan
A cash balance plan is a type of defined benefit plan (pension) that acts like a defined contribution plan (401K). When private companies were trying to get rid of their expensive pension plans, many of them converted their pension plans into cash balance plans, since they cost the company less. Employees didn’t like this, as their benefits were often lower, but it does provide an option for a physician or similar professional to shelter some more money from Uncle Sam. Here’s how it works:
How It Works
Every year your company (i.e. you if you’re the owner or a partner) makes a contribution toward the cash balance plan, usually at the end of the year on your behalf. That money is invested by your company’s chosen investment manager (you don’t choose the investments like in a 401K). At the end of the next year, your “account” (which legally is not technically yours, but the company’s) is credited with a certain interest rate, often fixed at something like 5% or a variable rate tied to the IRS treasury interest rate (3.88% currently), and another contribution is made by the company. That 5% comes from the investments the company made. If the investments did better than that, the company puts them toward future years in a reserve account. If they did worse, the company pulls from the reserve account so it can still credit you with 5%. If the plan has a big loss, the company may have to make a larger contribution the next year, but if the reserve account starts getting too large, the company can amend the plan and make an additional distribution to the “individual accounts” within the plan. In essence, the company is taking the investment risk, not you. Of course, for many doctors, you are the company, so you’re taking it either way.
My cash balance plan, with MedAmerica, set up defined benefit cash balance plan for our partnership a little differently. The Pension Protection Act of 2008 now allows the plan to pay the participants the actual returns of the plan instead of the IRS Treasury Rate, with the caveat that the return can’t be less than zero. The plan also decided to cap the return at 6.5%, with extra earnings (if they occur) going toward a reserve account to be drawn upon in the event of market losses. The money is invested across 8 mutual funds, in a 54%/46% stock/bond ratio. Each year an investment committee (made up predominantly of physicians in the plan) decides how much interest to credit the participants. In the event the investments have little to no return, participants don’t get an interest payment. In the event of a high return, the interest is capped at 6.5% and the rest goes into the reserve account. In the event of a really low return, the company has to make an extra contribution to the account to make up some of the losses. While that sucks to have to do in an economic downturn, especially when you’d rather be buying low yourself in your personal accounts, at least by doing so the plan is buying low, which should improve future returns. When you retire or leave the company, you don’t get any share of that reserve account even if there have been recent high returns in the plan, but nor are you required to make an extra contribution if the plan has a significant loss the year you separate from the company or partnership.
How much more could you have to contribute in the event of a severe market downturn? In 2008 the MedAmerica plan lost 22.8%. First the reserve account was applied, reducing the net loss to about 15%. By law that loss is spread over 5 years, so it is divided by 5. The “company” (i.e. the partners in the plan) had to make their regular annual contribution, plus 3% of what they had in their “individual account” in the plan at the beginning of 2008. So if you started 2008 with $100K in the account, and your annual contribution was $10K, the contribution due at the end of 2008 was $10K + 3%*$100K, or $13K. Of course, that entire $13K is tax-deductible. There was also a much smaller contribution due in 2009, but investment gains have the plan now back into a surplus.
Like in a 401K, the money grows in a tax-deferred manner, and you can’t access it before age 59 1/2, except for some limited circumstances, without paying a 10% penalty (plus the taxes due).
When you retire or separate from the company, you can either annuitize your “account balance” or you can take it as a lump sum, either in cash or by rolling it over into an IRA or another retirement plan.
How Much Can You Contribute?
That’s, unfortunately, a really complicated question. It depends on how much is in there and how old you are. There’s a law that only let’s you accumulate up to ~$2.5 Million into the cash balance plan. So the older you are, and the less you have in there, the more you can contribute. In general, you contribute either a percentage of salary or a flat sum (such as $5,000 or $40,000) each year. Of course, if you have employees, non-discrimination testing must be done and you should plan on contributing 5-7.5% of their salary for each of them. Maximum contributions may range from $50K for a 35 year old to $200K for a 65 year old. But many plans, due to actuarial restrictions and top-heavy testing, limit you to much less. Mine, for instance, currently limits partners to $15K per year (which knocks about $5K off my federal tax bill and another $750 off my state tax bill.)
Watch Expenses
Expenses for these plans can be considerably higher than for a 401K plan, because they have to be run by an actuary. My plan charges 0.6% of plan assets per year, in addition to the expense ratios on the funds used in the investments (which range from 0.07% to 1.26%).
A Good Option for Partnerships
According to a presentation put together by KravitzInc.com, 28% of cash balance plans are run by/for physician partnerships, another 9% by dentists, and a further 9% by attorneys. Despite the additional expense, the immense tax break available, as well as the asset protection (generally fully protected from creditors, just like a 401K) make them particularly attractive to these professionals. The flexibility available through the plans is also a huge benefit. Partners can make different contributions, the plan can often be made physician-only, liability between partners can be managed, and you can scale back on contributions or even amend or terminate the plan relatively easily if cash flows decrease.
A cash balance plan is a far better option for additional tax savings than purchasing a variable annuity or cash value life insurance since it not only grows in a tax-deferred manner, but it also gives you an upfront tax break and lower expenses than most life insurance products.
What are the downsides?
It’s possible the investments perform poorly for a long period of time and you have to make up the interest payments out of your cash flow. That doesn’t seem like a big deal if you have to make up a 5% payment on a $50,000 balance ($2500), but coming up with $50K could be a huge issue if you have a $1 Million balance. If you’re not already saving $50K into a 401K (and probably maxing out backdoor Roths for you and your spouse), then you’re unlikely to benefit from a cash balance plan especially given the decreased flexibility and higher expenses which drag on returns. The average physician (making $200K) probably doesn’t need one of these plans simply because she doesn’t make enough money to really benefit from them.
Although the money in the plan technically belongs to the company, not you, the assets must be managed for your benefit and are not subject to the company’s creditors. The pension is also usually insured by the Pension Benefit Guaranty Corporation, a government entity. Your company generally pays $35 per year per participant for this insurance, but may be exempt if there are fewer than 25 employees.
Also, if you’re required to make significant contributions for your employees, this can be an additional practice expense, eliminating the personal benefit to you, the owner.
There are three major disadvantages of a defined benefit plan such as this:
1. You are required to contribute to them. Unlike your defined contribution plan such as a 401k, you must contribute yearly to this. Thus if you have a bad year and wanted to forgoe a contribution, you really cant do that with this. While you can terminate such a plan (ususally rolling over the money into a defined contribution or ira), if you dont keep the plan for at least 5 years, the IRS seems to take notice and might fine you/disallow the previous deductions.
2. If you have a bunch of employees then it is more costly bc you will need to make payments on their behalf. Sometimes this helps you keep good employees, sometimes they would just prefer more cash in hand.
3. It is more expensive to administer. My plan costs about 2k per year just to administer not including any transaction fees. I personally dont have any AUM fees bc i manange it myself. Schwab seems to have the cheapest of these plans and i think their yearly fee is around $750.
A defined benefit plan also affects how much you can contribute to a defined contribution plan. In my situation, im now limited to around 32k per year for the employee/empolyer combined contribution.
In the end, these are best for physicians who are either older, dont plan on working a long time, and have few employees. Avoid any person who tries to get you into a 412i or 412e plan. These plans have the highest deductions but you get the same defined benefit so in the end you just pay more for the same retirement benefit.
1. True, but the required contribution can be set quite low. It’s $2250 a year for the plan I’m in with the option to put in up to $15K.
2. I don’t believe this is necessarily true. I believe if nothing else you can put employees in a different class than owners and thus contribute little to their “accounts.” Here’s a link to an example where the owner gets to put in $60K but only has to put in $2K for the staff.
3. For sure. I’m not too familiar with a 412i, but according to this both 412i and 412e are insurance based pension plans, thus mixing insurance and investing, which is usually a bad (and expensive) idea.
1. Yes but if you set the required contribution to be low (by reducing the defined benefit), then the costs of these plans make it such that there arent a good idea. This is one of the reasons why it is better when you are older, you are allowed a larger contribution/deduction in order to obtain the defined benefit.
2. While there are ways to reduce amounts for other employees, there are limits to this and the more employees you have, the more it adds up.
3. The reason i bring this up, is that whenever one is talking about any type of DB plan, it is important to focus on the benefit and not the contribution. Since most of us here about these as ways to reduce taxes, we mistakenly think that more is better. What if i said, i could put you in a DB plan, that even more reduces your tax burden by allowing you to contribute more than 3 times what you are currently contributing and its all tax deductible. At first thought, you might think that sounds great but thats bc you might mistakenly think that by contributing more that you will get more benefit later on when you retire. This isnt the case. With all DB plans the benefit is set to a certain number up to the current max of 200k per year. No matter how much you contribute, you will never get more than that thus what you really want is to contribute the least (in a realestic manner). Sure you will need to pay more taxes but you will still get the same benefit in the end and have more money in your pocket at the moment.
As an additional sidebar, if one has both a DB plan and a DC plan and they have a mix of conservative and aggressive investments (but not too aggressive such as index funds as aggressive and bonds as non aggressive), then one might want to put the conservative into the DB plan. This assumes that over the long haul the aggressive does better. If you are a serious gambler and like buying a bunch of individual stocks then you might do the reverse since when you actually figure out that you cant pick stocks, you will be allowed to contribute more to the DB plan to maintain the same defined benefit.
Also, the ability to put different employees into different classes for both db and dc profit sharing plans is limited largely by the ages of the different groups. If the physician partners are older and the support employees younger this works great. However, if the partners scew young, and the employees older, then you get very little benefit from grouping.
While this plan can be good, it’s best for the investors to realize the huge difference between retirement planning and investing. The key to a successful retirement planning is to diversify your investments to places where you can preserve your money and at the same time make some on top of the investments. Click here to learn how hybrid income annuity works.
The most popular of these hybrid income annuities are equity-indexed annuities, and they are generally products made to be sold, not bought. They have many disadvantages when compared to a cash balance plan, including the loss of the valuable up-front tax deduction.
WC u are being generous. The above is nothing better than spam. Annuities are typically a horrible idea as an investment.
One thing I should mention is that if taxes do rise, you may wish to consider just putting in the minimum funding this year with the idea of a larger deduction next year after taxes rise. Of course this assumes taxes rise.
My 5 physician group was planning on enrolling into a CBP. I was disappointed with Medamerica as they were not replying to my emails. Anyone else have suggestion regarding any other providers with low expense ratio/fees?
I’m hoping to have another guest post soon from a doc who is trying to get one set up.
I’m currently setting up a plan for my group with 50 physicians. We are an anesthesia group, and only have a dozen other employees so we are very top heavy. This kind of group is ideal for a cash balance plan. We contacted Vanguard and they put us in touch with an actuarial group that sets these things up. We have spoken to a few different administrators and it will cost between 11k and 18k a year to administer the plan. We intend to use the short term bond index as our benchmark, and will invest in the matching Vanguard fund to minimize the chance we have a shortfall at the end of the year. Different classes will be setup. $5000 will be the low, and we will likely do a couple of other tiers, maybe $50k and $100k. You have to meet PBGC guidelines, so your Administrator will tell you how much you can contribute.
So this was the fee proposed by Medamerica for our 5 physician group. We do not have any other employes- I think the fee is pretty steep for a 5 person group. What do you guys think?
401k VALUE FEE (Billed directly to each fund or self directed account)
.40% on the market value of the account (taken directly from the plan)
401k PARTICIPANT CHARGES (Billed to each group quarterly)
$6 per participant per month
DEFINED BENEFIT VALUE FEE (Billed directly to plan and subject to minimum)
.60% on market value of the account (on first $2,000,000 of assets)
.40% on market value thereafter
Minimum Annual Fee for either a single or combined plan:
Additional Fees:
MEETINGS IN EXCESS of ONE TRIP PER YEAR
Does not include initial enrollment meetings
$500 per day plus expenses
401k Participant Loan Setup (paid by individual)
PLAN DESIGN / ACCOUNT SET UP FEES
$10,000 *
(includes plan design, IRS filing fees, Schwab account set up fees, employee meetings
for both a 401(k) and defined benefit plan and other ancillary costs)
Pension Benefit Guaranty Corp. (“PBGC”) Premiums paid by Defined Benefit Plan
TERMINATION FEES
401(k) SELF DIRECTED CHARGES (paid by individual only if option is utilized)
VALUE FEE
$200 annual charge per account (billed annually by Schwab in January) on balances
up to $500,000, $500 on accounts with balances over $500,000.
TRANSACTION FEES
Subject to the standard charges as published by Chas. Schwab & Co. (Schwab.com)
Internet trades
$12,000 annually
$50
$5,000 within first two years
Waived thereafter
$8.95 per trade
That’s very similar to what our group pays MedAmerica (spread out among a lot more docs). What seems steep to you? The initial fees or the ongoing? I’d be interested to hear if you find someone doing it for significantly less.
Well I am not familiar with the prevailing rates for setting up the account, so I thought the rates were high. Guess the rates are competitive. We are planning to get quote from another vendor too. Will update you if anything works out cheaper.