Should I Use A Cash Balance Plan?

Show Trancript

Jimmy Turner MD

Cash balance plans are interesting, but I’m going to be honest, Justin, I know about them academically.

Jimmy Turner MD

I’ve read about these things. I know of them, understand a little bit about them, but I am a W2 employed physician who does not have access to a cash balance plan. So maybe let’s start with what these things are, who has access to them, that sort of thing.

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Justin Harvey CFP

Yeah. So a cash balance plan, cash balance pension plan, it’s a defined benefit plan. So the two primary categories into which retirement plans fall that are employer related are defined contribution and defined benefit.

Justin Harvey CFP

A defined contribution plan is limited by the amount of money you can put in every year and the limit is stated in a contribution amount. These would be most of the things that listeners are familiar with like a 401k, 403b, 457, defined contribution.

Justin Harvey CFP

So you can put in the max of, you know, 23 ,000 or 30 ,000 or, you know, you’re limited on the contribution side. The defined benefit, it’s not a limitation on how much money you can put in explicitly.

Justin Harvey CFP

The max contribution is defined in terms of the actuarial benefit related to how much money you can take out in the future. So when we’re talking about DB plans, they’re their own thing and they take more calculation horsepower to administer than something like a 401k.

Justin Harvey CFP

And actually, there’s probably 401k people that would disagree with me on that. In the ways that most of us interact with 401ks and the ways in which a business owner is going to interact with the DB plan, in this case, a cash balance pension plan specifically, there’s a couple more people involved, a couple more professionals, and there are some moving parts and some lack of predictability because you’re looking at your census for your practice,

Justin Harvey CFP

you’re looking at the ages and the income levels of the people who are involved, and you’re going to have to make contributions amounts based on the ages and income levels of your employees. And so the changing head count in your practice may actually significantly impact whether or not a DB plan is a good idea because what you might find is it’s getting way more expensive based on your census, or it is also linked to how the market performs because you’re promising a benefit amount of pension essentially for your employees because you’re promising them that there is a pool of money that you’re contributing into.

Justin Harvey CFP

And that is being invested by an investment manager. So whenever markets are bad, in order to continue to appropriately fund to be able to meet the promised payment amount to your employees in retirement, sometimes it gets quote unquote more expensive and the cash outlay required is significantly more than in some cases was anticipated.

Justin Harvey CFP

So it’s a little more complex and it requires strong revenue and profitability and a pretty good handle on your employee’s census and also a clear picture of your goals in order for the the DB plan to make sense.

Justin Harvey CFP

It’s sort of like that if the 401k is the 101, this is sort of like the 201 in terms of complexity and whether or not it fits into your financial plan.

Jimmy Turner MD

So I’m gonna simplify this a little bit. So there are math nerds that sit in a room and do lots of math things to basically allow for somebody to get the same amount of money every year that they’re in retirement, right?

Jimmy Turner MD

So you can think about an old school pension plan, you pay into it and then you get X number of dollars every month when you retire. And there are a bunch of actuarial, complicated conversations and problems that must be solved in order to do that.

Jimmy Turner MD

The take home here for me, like just as a physician on the front line reading about these things, some of it’s super exciting and some of it gives me quite a bit of heartburn and it could be theoretical heartburn.

Jimmy Turner MD

I don’t have the practical knowledge from an in use standpoint to be able to say this, but one you just mentioned. One is, okay, this thing is guaranteed. It’s a defined benefit on the back end. And so if you are still contributing to this thing and Dr.

Jimmy Turner MD

Jones who retired four years ago needs to get their $100 ,000 per year out of this defined benefit plan, and the market goes down, well, the only way to make sure that the defined benefit plan continues to exist is for you to potentially have to put more money in it.

Jimmy Turner MD

It’s almost like we’re getting called like options trading. We’re like, hey, stuff went down. So you got to put more money in so that we can pay Dr. Jones their $100 ,000. And in the last 12 years, probably doesn’t give a lot of heartburn because the market’s just gone up and up and up with outside of the pandemic bump it took.

Jimmy Turner MD

But for me, like that’s not something that gets me too terribly excited. And also there’s the way that the interest is calculated in these plans may or may not keep up with inflation depending on how conservative you are.

Jimmy Turner MD

And so the way that these things are designed, they’re complicated. There’s lots of math that I don’t understand. But what I do understand is that there are on the con side, the potential for them to ask you to put more money in so that they can actually provide that defined benefit.

Jimmy Turner MD

The interest may not keep up with inflation if you make it too conservative. You often want these plans to be conservative for a variety of reasons that we don’t necessarily need to get into. But there is a one massive benefit and that is that you can stuff quite a lot of money into these things like over $200 ,000 depending on your age.

Jimmy Turner MD

And that is a huge tax shelter, right? So the question that came in from the listener was like, people are gonna save so much money in taxes on these things. That can be really true. Can be a lot like multiple six figures kind of money.

Jimmy Turner MD

But it’s not all rainbows and sunshine.

Justin Harvey CFP

That’s right. And I would actually amend what you just said, not to say that they’re going to save a bunch of taxes, but they’re going to reduce their tax bill in the current year. That’s an important distinction, but you’re precisely right that what, you know, if like Justin, why would anyone do this thing?

Justin Harvey CFP

It sounds kind of complicated. I need to like maintain profitability and there’s this potential for a cashflow crunch. What’s the point? Well, if you’re going to get a big six figure tax deduction in your business in the current year, like that’s pretty compelling.

Justin Harvey CFP

And Jimmy, I, as much as anyone will say, like, if you can, there’s a lot we don’t know about the future, about the markets, about tax rates. If I can get a big tax break this year, we should at least strongly consider just taking it because you know, a dollar in my pocket today, who knows what’s going to happen tomorrow.

Justin Harvey CFP

So I certainly am biased in the same direction in terms of tax planning, decision -making. And there are some, so let’s profile a group for whom this might make sense. You can put more money into this account for your, your personal account for it.

Justin Harvey CFP

So if I’m a physician, I’m a practice owner, and I’m maybe in my fifties, and I’m making, you know, more than three or four hundred thousand dollars a year, I’m going to be able to hit pretty much the max contribution for my age.

Justin Harvey CFP

The rest of the employee census is really important. So this is where you’re going to say, okay, I’m Dr. Jones, I make, I made $750 ,000 last year. I have, you know, Sally and Regina and Steve and Frank and, you know, the rest of the employee headcount, a couple of MAs, someone at the front desk, maybe an NP, their age and their income is going to create a required contribution for each of these folks.

Justin Harvey CFP

So you might say as a business owner, okay, I can allocate, based on my cash flows, I can throw half a million dollars of total DB contributions into our defined benefit plan across all employees. Now remember, if you’re a business owner, you got a half a million dollars and you got a decision to make about it.

Justin Harvey CFP

If you don’t do a DB plan, you’re basically going to put that in your pocket. You’re going to pay yourself a half a million dollar bonus, or you’re going to reinvest it in your practice, your business in some other way.

Justin Harvey CFP

So it’s helpful to think about this like a tax, a tax rate question. So if I’m the high earner, if I’m the oldest person in my practice, I’m going to be able to bias the contribution towards me. So maybe if it’s half a million bucks, maybe 300 ,000 is going to go into my account.

Justin Harvey CFP

And the other 200 ,000 is going to be spread amongst all my other employees, sort of pro rata based on the actuarial components. Now that might sound like a good idea, like I’m keeping 60 and 40% that’s going to everyone else is sort of the quote unquote tax rate, you know?

Justin Harvey CFP

And you might say, yeah, I’m getting a big deduction. And maybe that’s a 60%, to be honest is like, I’m, I’m probably not jumping out of my chair thinking this is the best thing ever, because remember, this grows tax deferred, then you’re going to take that out later and you’re going to pay taxes on it at ordinary income rates.

Justin Harvey CFP

Cause the way that these usually function is I’m Dr. Jones, I’m the founder, I’m setting up a DV plan and I’m funding it. I’m going to run this DV plan for a handful of years, and maybe I’m going to shut it down at some point.

Justin Harvey CFP

And often what happens is it’s, it’s a traditional asset for tax purposes. It just gets rolled into an IRA. So it’s kind of like a bolt on to your 401k in terms of the tax treatment. And then you can stuff a bunch of money, you know, a million or two, and then it becomes part of your traditional retirement assets down the line.

Justin Harvey CFP

That also means that you’re going to access it at ordinary income tax rates. It also means that it’s going to be subject to RMDs later on. And it also means that if your heirs receive it, and this is why I sort of pushed back on the, Oh, we’re saving on taxes.

Justin Harvey CFP

Like, well, not actually. Cause if I die when I’m 87 and my 50 year old kid inherits this and my 50 year old kid is also a doctor and he’s got to kick out this whole traditional IRA to himself and a handful of years, and he’s already in the top margin.

Justin Harvey CFP

Did I really save taxes? Probably not compared to giving myself a half a million dollar bonus in, in that tax year and then investing the whole thing tax efficiently, the whole net proceeds in a taxable investment account, which gets a step up in basis.

Justin Harvey CFP

When I die, it’s a, it’s a, you got to understand the final disposition of the assets to know what is the tax benefit here. And not to put, you know, we’re down in the weeds right now, but the point is if you’re a physician getting on in years and you have younger staff who earn significantly less than you do, that is the sweet spot in terms of funding.

Justin Harvey CFP

And it’s worth, at least at that point, asking the question, bringing in some talking to an actuarian, someone who can set up a plan for you and say like, what do the numbers look like? And if I’m a doctor, what I’m looking for is what is that?

Justin Harvey CFP

I put it in air quotes, the tax rate, like how much can I fund for me versus how much do I need to fund for my staff? And if it’s like 80 20 or 90 10, it’s kind of a no brainer, or at least it’s much more favorable than, well, it’s like 60% me, 40% my staff and the tax case that you can make at that point is much more dubious.

Justin Harvey CFP

Now it’s still great for retention. It’s great to, if you, if the point is to like, I want to be able to attract and retain talent and I want to be able to help my employees. And this is a core part of the way I’m setting up the, all the different compensation mechanisms in my practice.

Justin Harvey CFP

Then you might do it anyway, but you got to understand that how the money is going to be shared amongst staff.

Jimmy Turner MD

Yeah, I think one thing that makes it challenging to talk about cash balance plans is that you can talk to 10 different managers that are going to institute a plan and get 10 different answers and 10 different plans.

Jimmy Turner MD

And there are minimum requirements in terms of the number, like the percentage of people in your group that need to participate in order to have a cash balance plan, and those numbers can be different too.

Jimmy Turner MD

And so it really is kind of a case by case basis. I know people that have overfunded their defined benefit plan, their cash balance plan. And so that that’s another situation that can come up for people at times.

Jimmy Turner MD

But yeah, so so if the mid 50s practice owner who decides that they can fund this thing, and that 80 or 90% of it’s going to go towards theirs versus the 10 to 20% is going to go towards their staff or to younger practice owners in the group, if that’s the person that is for I’ve heard some people say that they don’t like these plans when they are younger.

Jimmy Turner MD

And so tell me more about that. What why is that a thing? And why is the younger physician sometimes at odds with these plans that are clearly very beneficial for older docs?

Justin Harvey CFP

Yeah, so the contribution amount is based on, there’s a number, it’s sort of like a magic black box number. Right now it’s $3 .1 million. Math nerds doing math things. Yes, that is the maximum amount of benefit that a participant can receive from one of these plans.

Justin Harvey CFP

And in order to hit that, in order to like hit that 3 .1 million, you need to participate for a long time and make the maximum amount of money. And over your lifetime, if you start later, then the, in order for you to get that 3 .1 million and you start at age 57, you’re, you’re chunking in big amounts every year to get there within a handful of years.

Justin Harvey CFP

If you’re much younger, the same end point applies to you that 3 .1 million sort of lifetime contribution. But if you’re 31 years old, you just, you have a much bigger denominator. You’re dividing, instead of dividing by like, Oh, I have seven years to contribute to this.

Justin Harvey CFP

If I’m, you know, in my fifties, if you’re 31, you’ve got dozens of years. And so it’s that max, that max annual fund is a much smaller number. And so particularly if you’re an owner, that means that makes the math much less favorable because you’re only getting a very small minority of the total total dollars contributed compared to if you were further along in years.

Justin Harvey CFP

And so this does tend to be more of a tool used by older decision -making business owners to be able to take advantage of that sort of short denominator. We have less years, we have a high income, and the rest of our employee census is hopefully younger and making less.

Justin Harvey CFP

That allows you to really bias toward the owner in terms of account funding.

Jimmy Turner MD

Yeah, so I guess some some take home points, Justin, and maybe you can qualify these if you disagree. But some of the benefits that I understand about these plans we talked about on the show is the tax deductible nature of the contributions that you put in.

Jimmy Turner MD

It does provide a predictable benefit in retirement, because it by definition is a defined benefit plan. And the employer can also contribute a specified percentage of the employee’s salary each year.

Jimmy Turner MD

And that can be beneficial from a business side, but it does kind of come into question from a tax standpoint, depending upon how old you are, the younger you are, the less money you can put in because you have the longer period to do it.

Jimmy Turner MD

So it’s not as advantageous from a tax sheltering standpoint, if the market goes down, your plans to conservative, you may get that call to put more money in. And one thing we didn’t mention directly that’s a potential con these plans is that by definition, if it’s done by a manager, it’s invested by a manager.

Jimmy Turner MD

And so your investment control is less than what it would be inside of a taxable brokerage account, or potentially even a regular 401k, they’re going to invest these assets based on the plan that was created when you defined it.

Jimmy Turner MD

And maybe you’re joining a group and they already have the defined benefit plan, you didn’t have any say in it. So you have no control. Is this 90% stock 10% bonds, not often a great idea inside of a cash balance plan?

Jimmy Turner MD

Or did the people decide no, we’re gonna go 4060. And what would that mean? So you don’t have as much in control over the investments. Obviously, you’re listening to this, at some point, your eyes glazed over as you’re listening to the show, because it does, it does get into the weeds here.

Jimmy Turner MD

And so the take home there is that these things are complicated. You asked 10 different people to create a defined benefit plan for your practice, you’re gonna get 10 different answers 10 different products, they are just they’re just more complicated.

Jimmy Turner MD

So lots of homework to do lots of things you need to work to understand. And, and they are also obviously because of all this, and you said this earlier, I would say in my reading of this, I would agree they’re more expensive.

Jimmy Turner MD

Now, you mentioned that a 401k person may say, Oh, my stuff’s complicated. But by and large, these are more complicated, they are more expensive for the practice, and they do come with some downsides.

Jimmy Turner MD

That said, the tax deduction is a big benefit depending on how old you are.

Justin Harvey CFP

And understanding your goals and your balance sheet and even your spousal situation, like if you’re married, if you’re married to a doctor, if your doctor’s, if your spousal physician or whoever you’re married to, if they’ve been making money for a long time, there’s an important sort of longitudinal perspective that needs to be applied here and an understanding of specifically want to talk about balance sheet,

Justin Harvey CFP

like how much traditional assets do you have right now? Because if you start at age 31, you finish training and you start maxing out your 401k and you do that for three decades, you’re going to, depending on, you know, market returns and everything, you’re going to have conservatively four to $5 million and maybe way more in traditional assets at the time of your approaching retirement age.

Justin Harvey CFP

And it could be significantly more than that. If you have five or six or $7 million in a 401k, your RMDs required minimum distributions, especially if there’s two earners who have done that, they’re going to be well into the several hundred thousands per year already.

Justin Harvey CFP

And so there’s not a significant tax arbitrage here for that type of couple, because you’re now going from 7 million of traditional assets to 9 million of traditional assets or however much you’re going to fund with your DB plan later on.

Justin Harvey CFP

And so you’re kind of creating a future tax problem for yourself. Your RMDs are going to be bigger and what your heirs inherit is going to be tax disadvantaged on a relative basis. But if you have very little in traditional assets and you’re getting into your 50s, you’re like, Oh my gosh, I’ve never saved anything for retirement.

Justin Harvey CFP

I need to mash down the gas pedal and it’s go time. This is actually a much better fit for you. And if your spouse has either stayed at home or doesn’t have significant retirement assets as well, it’s a much better fit.

Justin Harvey CFP

So I’m not like necessarily opining, these are good, these are bad. They’re just very individualized and working with a team of advisors who like understand your goals, can understand good plan implementation and walk you through this is very important in this area in particular, because it’s one layer removed from what most lay people have ever interacted with and you’re going to be significantly dependent on your professional team.

Jimmy Turner MD

Yeah. And so a framework to think through this, I think that’s helpful. And that you’ve mentioned to me before is the thing that you’re going to be considering, right? Okay. Cash balance plan, good or bad?

Jimmy Turner MD

I don’t know. Depends on your situation. But the question is what else would you use? And so really in the situation, it’s cash balance plan versus potentially taxable brokerage account. If you’ve already maximized the other tax sheltered areas that you have available to you, just like with a 457, right?

Jimmy Turner MD

If you have a governmental 457, it’s basically an additional 401k or 403b. You should just probably use it if you’re looking to save more money. But if it’s a non -governmental and it’s at risk because it’s not owned by you until you have the money, and this isn’t a 457 show, maybe we should do one of those in the future.

Jimmy Turner MD

But suffice it to say, the question comes down to should I use this non -governmental 457 based on the big questions that are in play there, or should I put it in a brokerage account? I’d say it’s the same thing with a cash balance plan where should I do this cash balance plan with the caveats that you mentioned before about tax benefits?

Jimmy Turner MD

And are they really beneficial based on your situation and having stuffed $7 million away inside of a 401k? Probably not. But the question is, is that beneficial in my situation? Or should I put it into an alternative location for investing like a taxable brokerage account?

Justin Harvey CFP

Yeah, that’s a great way to distill it all the way down to sort of the essential question. And obviously, there’s a lot of flexibility in a taxable account. And there’s some estate benefits as well. But is that right for you?

Justin Harvey CFP

Depends on your goals, depends on your family depends on your balance sheet, it always depends. That’s a financial advisor, I can always say it depends and I’m off the hook. So you know that Jim.

Jimmy Turner MD

Personal finance is personal. Well everybody, thanks for listening. If you have a question topic you want us to discuss, jimmyatmoneymeetsmedicine .com. We love hearing from the listeners and the community and yes, I actually do respond to the emails that you send to me.

Jimmy Turner MD

So happy to always engage in questions, topics you might have that you want us to answer on this show. Before we head out, also want to mention that YouTube channel, I’m starting to make some dedicated videos on that channel that are separate completely from what we’re doing on the podcast.

Jimmy Turner MD

Lots of how -to videos and informational videos that are going up there. We’re also putting podcast episodes up on there occasionally. So if you haven’t checked out the YouTube channel, make sure to subscribe, join that journey.

Jimmy Turner MD

The very first video that I put out is actually on how to figure out how much you need to be saving each year, free calculator that I built is on there. You can check that out as well. That’s Money Meets Medicine YouTube channel.

Jimmy Turner MD

Appreciate all of you being a part of the community and we will see you next week. Cheers.

Justin Harvey CFP

Bye.

Jimmy Turner MD

Justin Harvey is a certified financial planner at APM Wealth where he helps anesthesiologists in pain medicine positions. Dr. Jimmy Turner is a practicing academic anesthesiologist at Wake Forest in North Carolina.

Jimmy Turner MD

He’s also a licensed insurance agent. However, either Justin or Jimmy are your financial planner, investment advisor or insurance agent. This show is expressly for general education and entertainment purposes only.

Jimmy Turner MD

Nothing should be considered financial advice. All views expressed are solely the views of the guests on the show and do not represent the views or opinions of their employer.