I’m a 45-year-old eye surgeon and I own my practice. This year I got nailed with a huge tax bill despite the fact that I maxed out my 401k and bought new equipment last year. I took home about $500,000 last year pre-tax. I have 10 employees who earn about $40,000 on average, and I’m carrying all of them in my profit sharing plan too. In your last column, you said that a defined benefit pension plan might save me taxes. I know there’s no free lunch out there, and I’ve heard these plans are kind of risky. Is it true? If so, what are the risks? Or are they actually a decent deal?
Looking at the headlines these days, you might begin to believe that “pension” is actually a four-letter word. Recent data from the Pew Center on the States showed that the country’s 100 largest pension plans are facing a combined shortfall of almost $1 trillion. That means employees in these plans are going to get a nasty surprise when they hit retirement age: way less money than promised.
But when I spoke with a few of the nation’s top “pension geeks” (that’s what they call themselves), I got an entirely different impression, especially about pension plans for small business owners.
“It’s kind of a shame,” said Michael D. Hughes, an employee retirement benefits attorney and pension guru based in St. Petersburg, Fla. “I think a lot of people are missing the boat by overlooking these plans,” he said. Defined benefit plans, particularly the new breed of plans known as “cash balance plans,” are often a slam dunk for high earning professionals, particularly those who already max out their 401(k) and profit sharing plan contributions like you do.
The Employee Retirement Income Security Act (ERISA) calls these “hybrid” plans, said Dan Kravitz, author of Beyond the 401k, and president of his own cash balance plan design firm in Los Angeles. They combine the features found in both defined contribution plans (e.g., 401k) and traditional defined benefit pension plans. As the business owner, you get a tax deduction for making contributions to the plan. As a taxpayer and a physician, your portion of the plan gains asset protection from bankruptcy creditors and can grow tax-deferred since this is a qualified plan under ERISA.
One more feature of cash balance plans makes them a win for your employees, too. Mr. Kravitz, who worked as a teacher before he began doing pension stuff back in 1989, still has an “old school” pension plan from his days as an educator. He said the school district’s plan is so complicated that, “I still have no idea how much money I’m going to get at retirement.” Since this is a benefit for your employees (not just a fat tax shelter for you), it’s nice for them to be able to look at their annual statement, see the cash balance, and know what it’s worth to them. It’s a nice feature if you’re aiming for higher rates of staff retention.
Unlike 401k plans, you as a business owner bear responsibility for the performance of the investments in your plan, and that’s where the risk comes in. By design, the plan assumes a rate of return or “interest crediting rate” that may be pegged to a benchmark (like the yield on the 30-year U.S. Treasury bond) or it may be set arbitrarily, usually at a rate near 4%. If your investments earn less than the interest crediting rate, you as the plan’s sponsor are responsible for making up the difference. That’s the bad news.
The good news is that eye surgeons can contribute way more money to a cash balance plan than they could contribute to a standalone 401k/profit sharing plan. According to Norman Levinrad, a pension actuary with Summit Benefit & Actuarial Services, Eugene, Ore., you might contribute as much as $120,000 more to a cash balance plan than if you had only a 401k plus profit sharing plan alone.
That extra contribution could save you about $48,000 in state and federal taxes, depending on where you practice and pay taxes.
There is one more catch but it’s manageable. The feds wants to make sure that everyone in the plan is treated fairly, so you will be required to include your employees in the plan and make a contribution for them as well. In this case, you’re contributing to their profit sharing plan accounts, so you may have satisfied the contribution requirements already.
So yes, there are some risks but the benefits far outweigh the costs. This is indeed a good deal for someone in a situation like yours.
Mr. Hughes believes now is a good time for physicians to consider setting up a cash balance plan, and he should know. He has been at this game a long time, having started his law practice just one year after ERISA became law, almost 40 years ago. “When you look at the tax and compliance issues surrounding these plans, it’s just about as good as it’s been since the 1980s in terms of what you can do and how you can design these plans.”
Speaking of design, I want you to know you will need a small team to make a cash balance plan a reality in your practice. First, you will need an actuary to calculate how much you can contribute to the plan. Next you will need an attorney to draft the plan documents. Once the plan is in place, you will need a bank, brokerage or mutual fund company to hold or “custody” the plan’s assets. If you’re crazy, you will manage the plan’s investments yourself, but if you’re smart, you’ll hire a registered investment advisor to do it for you. You will need a third party administrator or “record keeper” to keep track of the value of each participant’s balance in the plan. And you will need an accountant to file the plan’s Form 5500 each year, which is a report to the Department of Labor.
Sound overwhelming? Don’t fret. You can acquire each one of these team members independently (like you might if you called Mr. Hughes), or you can get them all in one place (like you might with Mr. Kravitz or Mr. Levinrad), though none of them offer investment management or custody services.
The all-in administrative cost for a cash balance plan might run you as much as $7,000 per year or maybe just a couple thousand more than you already pay for your 401k and profit sharing plan. All three of the pension gurus I interviewed for this column said that they would generate a free proposal to help you determine the costs and benefits of a plan for your practice, as is the custom in their line of work. At the very least, you or your office manager should make an effort to get further details.
Keep an Eye on Your Money
The key to financial security is vigilance. Get curious. Ask questions! Dig for answers … or email your questions to me so I can do the digging for you. If I use your question in “Eye on your money,” I will send you one of my favorite personal finance books to feed your head and a cool “Eye on your money” coffee mug to satisfy your thirst for answers.
Mr. Utley is president and founder of Physician Family Financial Advisors Inc., which delivers fee-only financial planning and independent investment advice to clients coast-to-coast. Contact him at 541-463-0899 or visit www.physicianfamily.com.