By Charles Cooke, CFP®
With summer’s arrival, you may be dreaming of retirement so that you can enjoy the R&R of the season all year long. As a practice owner, you have a unique retirement planning strategy often favored by high-earning entrepreneurs: the cash balance plan. By setting up a cash balance plan at your practice, you can build significant savings while reducing taxes. With a little savvy, you can control your tax bracket since the pretax contributions will reduce your income.
No matter where you are in the career spectrum, you may find the cash balance plan useful:
- Young dentists who own a practice can put themselves in a position to retire young. By contributing regularly, you can give yourself the option to work or to retire.
- Midcareer practitioners can use a cash balance plan to catch up. If you have been paying down loans or focused on the immediateneeds of careerand family, you may find yourself unprepared for retirement. A cash balance plan can help give you the ability to retire.
We often recommend that dental practices pair the cash balance plan with 401(k) and profit-sharing plans to really boost their retirement savings.
How It Works
A cash balance plan is a defined-benefit plan, or a pension. But it acts like a defined contribution plan, or 401(k). In other words, you (and your employees) will receive a specific account balance upon retirement or leaving the practice. The amount is guaranteed and does not depend on the plan’s investment performance.
Your practice sets up the plan with an actuary and makes annual pretax contributions. Each participant receives a specified portion of the contribution, as well as an annual interest credit. The credit is guaranteed and does not depend on investment performance.
The money grows tax-deferred, and when you retire, you can take the balance as an annuity or in cash, or you can roll the funds over into a traditional IRA.
Generous Contribution Limits
The cash balance plan shines because it allows you to contribute thousands of more dollars than you could with other retirement plans. How much you can contribute depends on your age. Some plans allow people age 60 and older to contribute over $200,000 each year.
Given that those contributions are pretax, the tax benefits are obvious. You not only have the ability to reduce your income taxes, but you could place yourself in a lower tax bracket.
The Triple Plan Combination
The dental practice owners with whom we work are often best served by combining a cash balance plan with a 401(k) and profit-sharing plan. A look at the numbers will show why.
Let’s say you have just a 401(k) and profit-sharing plan, with a maximum allowable contribution of $55,000. Assuming an annual investment of $55,000 for 20 years with a 7 percent return, your balance will total $2,254,752.
Now increase that maximum to $150,000 by adding a cash balance plan. Assuming the same time frame and rate of return, the balance will equal $6,149,323.
Depending on your age, you could invest more than $250,000 each year. Not only would this help you build a sizable nest egg, but you would reduce your adjusted gross income in the meantime.
A cash balance plan can provide an attractive way to save for retirement, increase your wealth, and reduce your taxes. However, it does have potential disadvantages.
- Expenses: The costs for a cash balance plan are generally higher than those for a 401(k) plan, including ongoing actuary expenses, administration costs, and investment management fees. You will want to review these expensesto make sure the tax benefits and saving opportunities outweigh the costs.
- Employee contributions: You will need to make contributions toward employee accounts—roughly 5% to 8% of their salary. However, this can be a selling point for your practice to attract high-quality employees. Plus, your employee contributions are tax deductible.
- Investment risk: The performance of investments does not affect the amount promised to you or your employees. Your practice (i.e., you) bearsthe investment risk. This may not matteras much if you have few employees since the bulk of contributions would be apportioned to you. In addition, your annual contribution requirements can be adjusted to account for fluctuations in net income.
A Case Study
Our client, Sandra*, came to us three years ago with a desire for financial freedom but without knowing how to achieve it. We set her up with a cash balance plan in addition to a 401(k) and profit-sharing plan.
In the past three years, Sandra has saved $500,000 in investable assets. Given that she is only 35, she has the potential to amass $8,084,166 by age 50. She would not be tied to the chair. Instead, she would have the freedom to work—or not.
Whether you are a young practice owner with a desire to retire early or a midcareer dentist who needs to catch up, a cash balance plan may be right for you. Combined with 401(k) and profit-sharing plans, you could use the generous contribution limits to save enough for a retirement that supports your desired lifestyle while enjoying wealth creation and tax savings during your career years. This guidance is general in nature, you should discuss these plans and you your particular tax situation with your tax professional.
Charles Cooke, CFP®, is the founder of Cooke Capital, a wealth planning and investment management firm specializing in dental practices.
*Not her real name.
This article was originally published in the North Carolina Dental Society’s Gazette.