When dentists consider retirement planning, they often consider a 401(k) plan. These plans are great options but come with contribution limits that fall short for many people. This is where a cash balance plan could be considered. They come with contributions that can top $300,000 annually, depending on your age and compensation.
However, before we examine the details of cash balance pension plans, let’s first understand the two types of retirement structures: contribution and benefit plans.
The most popular type of defined contribution plan is a 401(k). These plans specify a contribution that the employee and employer can make. Participants’ benefits upon retirement in a defined contribution plan depend on the cumulative plan funding and investment gains or losses, interest, and dividends. Depending on the age and annual limits, the combined contribution limits are approximately $60,000.
Defined benefit plans aim to provide a designated benefit at retirement for plan participants. This is generally a monthly payout similar to Social Security. The benefit amount is independent of employee contributions. It’s a specified amount typically based on the participant’s compensation.
Upon retirement (typically age 62), distributions will be taxed at the employee’s ordinary tax rate. In most situations, this rate will be substantially lower than the income tax rate during their high-income employment years.
But a cash balance plan is structured a little differently. It falls under the defined benefit plan umbrella. But to the employee, it has the look and feel of a 401(k) plan. This is because, unlike a pension, the payout amount is stated as an account balance rather than a monthly income stream.
As a result, a cash balance plan is typically called a “hybrid” plan. Like any pension withdrawals, cash balance pension distributions at retirement are taxed at the taxpayer’s ordinary income tax rate.
How do cash balance plans work?
In a typical cash balance plan arrangement, the employee’s account receives the company’s annual credit (often called a “pay credit”). This is usually around 5% of compensation as specified in the plan document.
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The employee’s account also receives an “interest credit.” The plan can come with a fixed or variable rate that can link to an index such as a U.S. Treasury note. Employees receive annual statements expressed in terms of an account balance.
How are cash balance pension plans differ from traditional pension plans?
Both cash balance plans and traditional defined benefit plans offer employee benefit payments based on a series of payments over the employee’s expected life. For traditional defined benefit plan structures, the payments would begin at retirement.
Cash balance plans will define the employee benefit based on a stated account balance. This account is generally called a “hypothetical account” because it does not reflect the actual account contributions or balance. They merely state an account balance under the plan document.
Why is a cash balance plan such a great retirement structure?
It allows plan participants to make large contributions and take a large tax deduction. Contribution limits are indexed annually by the IRS and based on age. Most dentists can make contributions from $100,000 to $300,000. These contributions compare favorably to the approximate $60,000 annual limitation of a 401(k) plan.
Let’s look at an example. Assume a 58-year-old dentist earns $500,000 yearly and seeks to maximize a retirement contribution. For simplicity, let’s also assume that the physician has no eligible employees (if the dentist had employees, they would be subject to minimum contributions under the plan).
Because of compensation and age, this dentist can contribute approximately $230,000 to the cash balance plan in the first year. When the cash balance plan combines with a 401(k) profit-sharing plan, the dentist can contribute an additional amount equal to the maximum employee deferral and the allowable profit-sharing amount.
Along with the rules for establishing annual contribution limits, defined benefit and defined contribution plans also have varying specifications for contribution requirements. In addition, to have inconsistent rules for setting yearly contribution limits, these plans have varying specifications for contribution requirements.
|Tax-Deferred Contributions||High Administration Costs|
|Rollover to IRA or 401(k)||Mandatory Contribution Levels|
|Flexible Contributions||Permanent Structure|
|Tax-Deferred Growth||Complex Plan Design|
Within a defined benefit plan, there is typically an annual contribution obligation. The employer must fund the amount determined by the actuary to sufficiently support the benefits specified. However, if the plan has been overfunded, the annual funding requirement may be decreased. If there is an inability to afford the funding requirement, there is potential for the benefits to be amended.
In contrast, within a defined contribution plan, contributions are typically at the discretion of the individual. This is true when it comes to corporations with only owner-employees. As a result, the business owner may determine annually whether or not they will contribute to the 401k.
Defined Benefit and Cash Balance Plans for Dentists
Plan contributions are fully tax-deductible. In addition, you can make contributions as late as the tax return if filed by September 15th (for a calendar year plan). Assuming a federal and state tax rate of 40%, this is a tax saving of $102,000. A good deal. This amount grows tax-deferred but will be subject to taxation at his (presumably lower) tax rate in retirement.
Consider the above example of the dentist. As you can see, only a few retirement options allow for such a significant contribution. A 401(k) plan does not come close.
Cash balance pension plans are great for:
- Companies with historically consistent profits.
- Professional service businesses (dentists, physicians, attorneys, CPAs, etc.).
- Businesses that are interested in improving morale and employee retention.
- Owners who are behind on retirement planning and are looking to “catch up” on retirement contributions.
- Owners in high tax brackets who are looking to maximize income tax deductions.
If you think a plan is right for your business, ensure that you review your financial and tax situation with your CPA and a retirement administrator. Hopefully, the cash balance plan will become an effective tool in your retirement arsenal.