The single best tax break available to physicians 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 $58K a year for 2021 ($64,500 if they’re 50+.) If your federal and state marginal income tax rate is 37%, you just knocked $21,460 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 special kind of defined benefit plan called a cash balance plan.
Two Broad Categories of Retirement Plans
Retirement plans can be divided into two broad categories.
#1 Defined Contribution
A 401(k) is an example of a defined contribution plan, where you contribute a certain amount each year. Depending on investment returns, that initial contribution may grow to be a small amount, a large amount, or even disappear completely. There is no guaranteed benefit at the end. All that is defined is how much you can put into it as you go along. The amount of money you will have to spend in retirement depends entirely on how much you put into the account and the performance of your selected investments. The risk is all on you.
#2 Defined Benefit
A defined benefit retirement plan works differently. The classic example is the increasingly rare company pension. You work for a company or government entity for 20 or 30 years, and after you retire, the company pays you a defined benefit for the rest of your life. The company takes all the investment risk. If the investments do well, the company can get away with putting less money into the account. If the investments do poorly, the company must contribute more to the account. But either way, there is no difference to you. You get the defined benefit.
Cash Balance Plans Are a Hybrid
A cash balance plan is technically a type of defined benefit plan, but it can act like a defined contribution plan in two important ways:
- Depending on how your plan is designed, you can actually change how much you can contribute each year (or if you want to keep your plan administrator happy, every few years) to the plan.
- Upon separation from the employer, or when the plan is closed for any reason acceptable to the IRS, you can transfer the money tax-free into a 401(k) or IRA, just like a 401(k) or most other defined contribution plans.
For most participants, the cash balance plan is essentially an extra retirement plan allowing for additional tax-deferred retirement contributions above and beyond those allowed in the 401(k). Perhaps the best way to think of a cash balance plan is that it is an additional 401(k) masquerading as a pension. It has to follow the actuarial rules that apply to pensions, but at the end of the day, (wink wink nod nod) we all know you’re just going to roll it over into your 401(k) in five or ten years.
When private companies were trying to get rid of their expensive pension plans, many of them converted their pension plans into defined contribution plans, transferring the investment risk from the employer to the employee and often lowering the cost to the employer (and the benefit to the employee). However, some companies simply changed their pension plan into a cash balance plan. Employees didn’t like this any more than seeing a 401(k) replace their pension, but this concept of a cash balance plan does provide an additional tax-sheltering retirement plan option for a physician or other high income professional.
How Cash Balance Plans Work
A cash balance plan seems complicated because, as a defined benefit plan, it must at least resemble a typical pension. That means the participants in the plan generally select or manage investments in the plan, at least not in the frenetic way that many frequent traders “invest”. The cash balance plan requires complicated actuarial calculations to determine the maximum contributions that can be made into the plan for any given employee. The contributions also must technically come from the employer, not the employee. Due to these complications, fees on a cash balance plan are generally higher than those in a 401(k). Unless you are an independent contractor with no employees (and maybe not even then), this type of plan is not a do-it-yourself project; you will need to hire an experienced company to design and run the plan. Our WCI Recommended Retirement Plan Advisors are pros at doing this and can customize the best plan for your business.
Contributions to the Plan
All contributions into the plan are generally pooled and invested together by the plan trustee. However, hypothetical individual accounts are tracked and credited with a certain amount of interest each year, depending on the performance of the underlying investments.
If the investments perform well, that credited interest rate may be higher up to a certain point, such as 5–7 percent per year. If the investments perform very well, the additional earnings, above and beyond the 5–7 percent limit, are allocated to a surplus account where they can be used to make up for future shortfalls in investment performance or to reduce future required contributions. If the investments perform poorly, the owners of the company may be required to contribute additional money to the plan to make up the losses over a period of a few years.
This aspect of defined contribution plans turns off many physicians (who are generally not only the participants in the plan but also the owners of the company). However, in reality, this mechanism is of significant benefit to the physician. In a market downturn, not only do you GET TO (also admittedly HAVE TO) defer even more money into the plan, but the make-up contributions are also deductible. You are essentially forced to buy low, boosting future market returns. 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.
Example #1: Predetermined Interest Plans
For example, in my old cash balance plan, it worked like this. The money was 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) decided how much interest to credit the participants. In the event the investments had little to no return, participants didn’t get an interest payment. In the event of a high return, the interest was capped at 6.5% and the rest went into the reserve account. If the return was negative, money was pulled from the reserve account. In the event of a really low return, the company (ie, the physician partners) had 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…