Dr. Timothy Maxwell has been in practice for over 25 years. He’s in his early 60’s and starting to give thought to what his retirement is going to be like. He’s looking forward to the ‘golden years’, but like all of us he’s worried about paying for them. In fact, after losing 25% of his retirement plan last year, he needs to start putting a lot more away. Also, his practice has continued to do quite well in these last years and his compensation has been consistently high. He needs to find a way to increase his pretax earnings.
His is a smaller practice with only eight employees and a 401k in place. As we discussed his concerns, it was clear that his retirement plan needed a boost to get “on track”. Ideally Dr. Maxwell needed both additional tax deductions and increased retirement savings. With the time being short, he needed to make deductible contributions greater than the annual additional maximum per person of $49,000 for a defined contribution plan, at least for himself and a few key personnel.
Dr. Maxwell is not alone in his concerns. Physicians often wait until the ‘last minute’ with only 5 or 10 years out to start saving for retirement. With this in mind, we decided to look at a cash balance plan to compliment the traditional profit sharingplan they had in place now. This can be very effective for high earners, particularly professionals, because the plan allows far more pretax dollars to be socked away than traditional 401(k) plans.
What is a cash balance plan?
A cash-balance plan is a defined benefit plan that is a whole lot like a traditional pension, but with a few elements that closely resemble a 401(k). Instead of the benefit in retirement being based on a formula that takes into account length on the job and average salary during the last few years of employment, the cash-balance plan credits the account with a set percentage of the employee salary each year, typically 5%, plus a set interest rate that is applied to the balance.
What would the advantages to Dr. Maxwell as the owner be? The contributions will cut his tax bill because it is deductible. The cash balance plan is a great recruitment and retention tool, too. It is often less costly than a traditional defined benefit plan. There is greater funding flexibility than defined contribution plans. There is opportunity to provide significantly greater or additional benefits than a defined contribution plan. The contributions for older key employees can easily exceed $100,000; In fact, benefits can approach a lump sum payout, depending upon age, of nearly $2 million per key personnel. And, doctors and other professionals vulnerable to lawsuits like cash balance plans because they are protected from creditors.
Dr. Maxwell is also concerned about his employees. He wants to make sure they would be happy with the plan as well. The advantages for his employees were just as significant. As the employer, the practice would pay the entire cost with no cost to the employee. The cash balance planis easy to understand. There are no investment decisions or investment risk for the employees. The plan has a portable account balance and if the employee leaves it can be rolled over. There is benefit protection provided by the Pension Benefit Guaranty Corporation (PBGC). And, compared to traditional defined benefit plans, it is more attractive to younger, mobile workers.
Since the passage of the Pension Protection Act of 2006 (PPA), conversions to cash balance plans have escalated. Why? The plan provides one of the highest contributions and tax deductions. And, the contributions for cash balance plans are calculated based on the employees’ ages, compensation and employee classes. The doctor decides the percent of contribution for each employee. Since this type of cash balance plan heavily favors the physician-owners or key employees, it is almost always set up in combination with a 401(k) plan so that together they satisfy nondiscrimination requirements. Cash balance plans are a great solution for physicians and employees alike.
Written by R. J. Kelly – September 2011