Co-authored by Mitchell Guralski, Wipfli Financial Advisors, LLC
Does your medical practice have a 401(k) plan in place? Are you maxing out your contributions to your 401(k) plan and still desire to save additional contributions for retirement on a pre-tax basis?
If so, then your practice could benefit from implementing a cash balance plan.
What is a cash balance plan?
A cash balance plan is a hybrid retirement plan with characteristics of both a defined benefit pension plan and a defined contribution (profit-sharing) plan, with contributions funded exclusively by the employer. While a cash balance plan may operate as the sole employer-sponsored plan, it is most commonly sponsored in combination with a 401(k) plan.
Medical practices typically make good candidates for cash balance plans because most practices are consistently profitable, enabling them to fund the mandatory annual contribution.
If the goal is to maximize the percentage of total contributions to the physician-owners, cash balance plans work best for smaller businesses with fewer employees, as it maximizes a larger percentage of the total contribution to the owners. As the business grows in size, the percentage of the total allocable to the physician owners will generally decline as the contribution is divided among a larger group of employees.
What are the benefits of a cash balance plan?
There are three primary benefits to physician-owners: Retirement savings, tax savings and an increased physician owner-share of the total contributions.
Retirement savings: A cash balance plan provides physician-owners the ability to greatly accelerate their retirement savings. Contribution maximums are determined by the age of the participant. For example, annual contributions for a physician owner can exceed $250,000 for those approaching retirement age. Conversely, younger physicians at the beginning of their career (early 30s) may be limited to contributions of $50,000 annually, depending on age. Thus, age demographics are key in determining overall contributions for each physician-owner.
When compared to the maximum contribution limits in a 401(k) plan ($61,000 and $67,500 [for those age 50 or older] for 2022 plan years), it can provide for significant increases in retirement savings. This alone can make implementing a cash balance plan well worth the effort.
Tax savings: As contributions to the cash balance and 401(k) plans increase, incremental tax savings are realized. As with other retirement plan contributions, each dollar contributed to the cash balance plan offers a tax deduction.
For example, if your medical practice has an annual profit of $500,000 and has a combined federal and state marginal tax rate of 40%, the corresponding tax liability would be $200,000. But if you design a cash balance plan with $300,000 of annual contributions, the medical practice can deduct the $300,000 and only pay taxes on $200,000 of profits ($80,000 tax bill). Not only do you increase retirement savings, but you have now lowered your current tax liability bill by $120,000.
It’s important to understand that retirement plans provide a deferral of taxation benefit over a period of time, which may span decades. In other words, the tax benefit realized is based on current tax rates at the time the contribution is made, whereas the tax liability generated from a distribution of the original contributions plus associated earnings to the participant is based on future, unknown tax rates. For most physicians, deferring income through pre-tax contributions during higher earning working years allows them to realize it at expected lower tax rates in their retirement years.
Increased physician-owner share of contributions: While increased retirement and tax savings can be beneficial for physician-owners, the benefits don’t stop there. Often, cash balance plans can also significantly increase the percentage of employer contributions going to the physician-owners.
Depending on how much your practice is contributing to employee 401(k) accounts, there may be little to no increase in contributions to employees via the cash balance plan. You’re also not required to offer the plan to every employee so long as you’re meeting minimum coverage tests.
While results vary based on employee demographics, amongst other items, the below example shows the power of the three benefits. A medical practice was able to optimize a 401(k)-only structure by moving to a combination 401(k) and cash balance plan, utilizing the same 10% of compensation, employer contribution structure.
By shifting a portion of their existing 10% contribution to the new cash balance plan, the physicians were able to realize the entire incremental contribution of $400,000. The additional contributions generated a six-figure current year annual tax deferral, and increased the total allocable contribution to the physician-owners.
How does a cash balance plan work?
Cash balance plans can be more simply explained by dividing them into two parts: pay credits and interest credits.
Pay credits: Pay credits are synonymous with contributions. They are expressed as either a percentage of compensation, or a fixed dollar amount. Cash balance plans have an annual, minimum funding requirement. This is computed by an actuary, and employers have some flexibility in contributing a range of contributions each year within acceptable limits. Unlike 401(k) plans, contributions to cash balance plans are not discretionary. Generally, the goal is to keep the plans as close to fully funded as possible, especially in situations where physician-owners are entering and exiting the practice.
Pay credits may differ for employees vs. physician-owners. For employees, the medical practice can set a percentage of compensation to be contributed to the plan, such as 3% of each employee’s salary. For owners, contributions may vary based on the owner’s personal cash flow and desired savings, but are restricted based on nondiscrimination testing and the overall employee age demographics of the organization. The pay credits may be amended periodically, but typically no more than once every three years.
Interest credits: Once you have dollars in the plan, it’s time to grow them.
Unlike a 401(k), in which the employee can direct their investments and assumes the risk of doing so, a cash balance plan places the investment risk on the employer. All plan assets are placed into a single, pooled account, which is invested according to a stock-to-bond allocation determined by the investment committee appointed by the medical practice, with guidance from an investment advisor (such as Wipfli Financial Advisors). Not only do you decide this important allocation, but your medical practice is also required to guarantee a specific rate of return for participants, known as the interest crediting rate. Typically, this is 3-5% (and is based on long-term Treasury yields). Because of this, the expected future returns for the stock-to-bond risk allocation should align with the interest crediting rate.
However, it is unlikely the underlying investment return from the portfolio will earn a return identical to the interest crediting rate. Any over/under-performance impacts the physician-owners’ cash flow. For example, let’s assume your plan’s crediting rate is 4%. This means your practice is required to provide each account with a guaranteed fixed rate of return, similar to a 4% certificate of deposit, regardless of the actual investment return of the portfolio.
If your investments earn a 7% return, for example, the additional 3% return earned in excess of the 4% interest crediting rate can be used to offset future contributions into the plan. If your investments earn 1% and thus underperform the interest crediting rate by 3%, the physician-owners must contribute additional contributions to make up the shortfall.
Due to these nuances, it is important to be thoughtful about investment risk and strategy so that it properly aligns with the interest crediting rate to avoid large swings in over/underperformance of the interest crediting rate.
Are you ready for a cash balance plan?
If you’ve maxed out your 401(k) and are looking to save more, it’s time to consider a cash balance plan. And it’s easy to get started.
Wipfli and our affiliate Wipfli Financial Advisors work together to analyze your current retirement plan benefits, including fees and investments, and discuss the goals of your medical practice’s owners. More tax savings? Using your plan as an employee retention tool? Is the plan meeting those goals? What can be improved?
If a cash balance plan could help, we can work with an actuary to run projections and assist with setting up the plan. Contact us to learn more.
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