Is Your Practice a Good Fit for a Cash Balance Retirement Plan?

MARCH 15, 2019
Matthew White, Partner at White and McGowan Financial
In my previous article, How A Cash Balance Plan Can Turbo-Charge Your 401(k) Plans, I explained the fundamentals of a Cash Balance plan and why these plans are particularly appealing to various medical practices.  

In this article, I’ll share guidelines to help determine whether your practice can enhance its benefits program by sponsoring a Cash Balance plan, along with a few important considerations as you make your evaluation.personal finance physicians cash balance plan retirement 401(k)

A recap of Cash Balance plans

Cash Balance plans have been around for more than three decades, but due to their perceived complexity, few understand their benefits. The first ever IRS-approved Cash Balance plan was implemented by Bank of America in 1985, but they didn’t gain broader awareness until 2006 when the Pension Protection Act (PPA) clarified certain legal issues and made the plans easier to implement. Since then, the number of new plans added has been increasing at an average rate of 20% per year – the more people know about them, the more popular they become.

A Cash Balance plan is a type of IRS-qualified retirement plan also known as a “hybrid” since it has features of both defined benefit and defined contribution plans. Cash Balance plans combine the high contribution limits of a defined benefit plan with the flexibility and portability of a 401(k) plan.

If you’re considering a Cash Balance plan, here are the indictors that your practice is a good fit for one.

Your practice has predictable cash flow and you can make consistent annual contributions.

If your practice and/or partners make a minimum of $250,000 per year you would likely benefit from a Cash Balance plan. One rule of thumb is that you should only start a Cash Balance plan if you know you have the ability to make consistent contributions to the plan for at least three years. Since contributions (a flat amount or a percentage of pay) are written into the plan document, they can be changed only by plan amendment. The IRS looks unfavorably on multiple plan amendments that seek to adjust contribution amounts.

In addition, a Cash Balance Plan, like a 401(k) plan, is considered a qualified plan. Therefore, if monies are withdrawn prior to age 59 ½ you’ll pay income taxes and a 10% penalty on the amount withdrawn.
 

Business owners or partners want to catch up on or accelerate retirement savings.

Cash Balance plans are best for those who need or want to contribute in excess of the annual contribution limits of a combined 401(k)-profit sharing plan, or more than $60,000. In fact, a Cash Balance plan can allow tax-deferred contributions that are significantly higher and can help owners or partners realize meaningful savings in a short period of time. For example, a 45-year-old business owner can contribute $168,000 to her retirement, while a 55-year-old could contribute $255,000 to his.

Practice owners or partners want to reduce the tax burden.

Anxiety about rising tax rates is a major motivator for business owners and high-income professionals, and the exclusion of medical professionals from the pass-through deduction under last year’s tax reform has been a major frustration. “Cash Balance plans offer a compelling strategy to reduce the tax burden and, in some cases, even move owners into a lower tax bracket, allowing them to take advantage of the 199A deduction,” said Dan Kravitz, president of Kravitz Inc., whose firm specializes in designing and administering Cash Balance plans.

The pass-through deduction requires a taxable income of less than $315,000 and the benefits of the deduction phase out completely when taxable income exceeds $415,000. If taxable income falls below the necessary threshold, the 199A deduction allows you to deduct 20% of your Qualified Business Income. This is a major tax benefit for those that qualify, but many struggle to have enough itemized deductions and retirement contributions to get their taxable income below the required threshold. The threshold is based on taxable income, not gross income; therefore, contributing to a cash balance plan would allow many physicians to reduce their taxable income below the necessary threshold to where they would qualify for the pass-through deduction.

Tax liabilities are the largest expense after payroll for many practices. Cash Balance plans provide the greatest possible benefit: an above-the-line reduction of Adjusted Gross Income that can result in savings of $100,000 or more.
 

Multiple partners in your practice want to benefit from a Cash Balance plan.

While not all partners need to participate equally (or at all) in a Cash Balance plan, it must be adopted by the entire group. If you’re a partner in a group, you cannot choose to have your own Cash Balance plan, it must be implemented for the whole practice.   

The good news is that not every partner is required to contribute. Some may choose to opt out if they prefer to receive all of their income today (minus applicable taxes), while others can choose to contribute various amounts based on what is affordable and allowable by the plan. One note of caution is that the amounts contributed by partners impact what the business must contribute on behalf of non-partner employees.  

This is very similar to the way that ERISA guidelines require business owners to offer matching contributions to eligible employees who choose to contribute to a 401(k) plan. The higher the contributions made by highly compensated employees, the higher the contribution must be for its rank and file employees. Qualified retirement plans always seek to maintain a level of fairness in contributions and benefits. 

Business owners or partners seek a financial asset that is protected from creditors.

As is the case with all IRS-qualified plan assets, Cash Balance accounts are protected from creditors in the event of a lawsuit or bankruptcy. If you’re like most physicians, there’s an underlying concern about protecting your personal assets from potential claims. Moving the money from your business and into the Cash Balance plan eliminates exposure to such risk and ensures that the funds will be available for your later retirement and heirs.

A cash balance plan can allow partners in a C Corp to avoid double taxation on profits.

One additional point worth noting. As a C Corp, you will be receiving a large amount of profit in comparison to last year, since the corporate tax rate was changed from the progressive tax system with rates as high as 35% to a flat rate of 21%. The corporation may decide to pay the corporate tax on the additional profit and increase the W2 wages of each physician; however, these dollars will be hit by the 21% corporate tax rate, as well as their personal income tax rate.

By adding the additional profits of the corporation to each physician through the Cash Balance Plan, you are avoiding the 21% corporate tax rate on all contributions and the W2 income is not increasing for each physician, which prevents the funds from being taxed as personal income today. This allows the additional profits from the tax cuts, and any additional profits for the corporation, to avoid the double-taxation these dollars would normally experience each year going forward. 

These dollars will be taxed at the physician’s income tax rate as they withdraw the money from an IRA during retirement. This will be at a much lower effective tax rate when compared with adding the additional profits to the higher incomes they make today. 

It's important to understand that the Cash Balance Plan allows you to avoid paying the 21% corporate tax rate on these dollars and allows for the physicians to defer paying income taxes on these company profits until a future date when their incomes will be much lower. The consequence of not using the Cash Balance Plan means the additional corporate profits incur the typical double-taxation that comes with being a C-Corp, just so the physicians can have a slightly higher W2 income today.

Without a cash balance this calculation shows the typical double taxation that may occur:

$1 - 21% (Corporate Tax) = 79 cents

.79 - 35% (Individual Tax Rate - Federal) - 6.9% (Individual Tax Rate - State) = 45.9 cents
(assumes additional income would fall between $400,000 - $600,000 for Federal) 
(assumes additional income would be above $35,001 for State)  

With a Cash Balance this calculation shows how it can help ease the burden of double taxation:

$1 enters Cash Balance Plan and avoids Corporate Tax and Personal Income Tax today.

At retirement, individual withdraws $1 and pays Federal and State Income Tax in that year. 

$1 - 22% (Individual Tax Rate - Federal) - 6.9% (Individual Tax Rate - State) = 71.1 cents
(assumes income withdrawn would fall between $77,401 - $165,000 for Federal) 
(assumes income withdrawn would be above $35,001 for State)  

Other considerations

If you’re independently contracted and receive 1099 income, you can sponsor a Cash Balance plan on your own. The Cash Balance plan works well in this scenario because all contributions will benefit you. Plus, you have full control over the plan’s structure, any amendments, and the investments of the plan.

Takeaway

As with the implementation of any qualified plan, it’s important to follow IRS rules and guidelines, hence the importance of using a third-party administrator and financial advisor that have experience with managing cash balance plans. As has been said by many before, there are two tax laws, one for the informed and one for the uninformed. Many settle for the tax benefits that are most widely known and typically used, rather than learning the full extent of what the tax law offers resulting in unnecessary taxes and significant opportunity cost. If you are 50 years old, you could contribute as much as $158,000 pre-tax to a cash balance plan this year.

Assume this 50-year old would normally pay a 35% tax rate on this $158,000 because they don’t have a cash balance plan. The tax savings on $158,000 would be $55,300 for that year and that’s not accounting for State and Local taxes. If you invest the tax savings of $55,300 and assume the growth rate of the S&P 500 over the last 15 years as the earning rate for the next 15 years, this person would have a total of $180,858 by the time they’re 65.

They’ll withdraw these funds during their retirement years and pay taxes, but it’s likely this will be at a much lower tax rate than the 35% they’re avoiding as they’ll be withdrawing the minimum needed to cover their expenses. If we assumed the 50-year old withdrew the entire amount of $180,858, at age 65, the federal tax bill would be $41,223 under the new tax law, if married filing jointly. In addition to the growth of the $158,000 contribution to the cash balance plan is the growth of the tax savings invested over the next 15 years. This comes to a net after-tax gain of $139,635. What’s amazing is that $139,635 is the savings, in this one scenario, created by contributing to a cash balance plan for one year. Now, just imagine what the calculated benefit would be if the 50-year old decided to continue contributions for the next 15 years. 

For more personal finance insights, read on here!


If you currently max out your retirement plan options and have additional cash you would rather not pay income taxes on today, contact matt@whiteandmmcgowan.com!

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