A Guide to Doctors’ and Lawyers’ Favorite Vehicle to Reduce Taxes
Recently, the Wall Street Journal ran a helpful article detailing why cash balance plans are the fastest growing and most popular part of the pension world. In fact, assets now number greater than one-trillion. If you have not heard of them that is because while these plans are fantastic they are best suited to a niche audience:
1) You must be an owner of a small business (lawyers, doctors, real estate developers, accountants, etc.)
2) Your small business must be generating significant profitability
If you qualify, keep reading.
Everyone who hears about cash balance plans is always both intrigued and a little confused. After all, their are key differences between 401(k) plans and cash balance plans. Helpfully, the Wall Street Journal ran a recent Q&A with readers after their excellent article introducing cash balance plans. Not everyone has a Wall Street Journal subscription, so here are a few of the highlights of the Q&A from the follow-up article:
Q. How is the Money Invested?
"While 401(k) participants typically choose their own investments from their plan’s menu, cash balance plans generally hire a professional to invest the money.
Since many of these plans guarantee a fixed annual return, often 3% to 5%, the managers typically choose relatively conservative strategies weighted toward fixed income. That helps minimize losses the employer would eventually have to make up with additional contributions."
Q. Who Can Use the Plans?
"You can’t use a cash balance plan unless your company offers one.
In the 1990s, many large firms converted their traditional pensions to a cash balance model, often to reduce the volatility of their pension expenses. Many have since shifted new hires into 401(k)'s.
In recent years, cash balance plans have grown in popularity with smaller employers, including medical practices and law firms. Companies with nine or fewer employees make up 61% of all cash balance plans.
Many smaller companies with cash balance plans pair them with 401(k)s to pass annual tests the Internal Revenue Service requires. To pass, employers must generally contribute 5% to 7.5% of pay to the accounts of eligible employees who earned below $155,000 in 2024."
Q. How Much Can I Contribute to the Plans?
"This year, the IRS allows people to accumulate up to about $3.6 million in a cash balance plan by age 62. That limit rises to $3.8 million for those working until age 68. The IRS adjusts the limit each year for inflation. Accumulating enough to receive a benefit of that size typically takes about 10 years. Contributions for older participants are often higher since they generally have higher incomes and less time to reach the maximum inflation-adjusted balance. In some plans, higher earners between 66 and 70 years old can put away as much as $380,000 a year."
Q. What Happens to My Cash Balance Plan When I Stop Working or Change Jobs?
"Participants in cash balance plans typically roll their savings over to an IRA or 401(k) when they leave their company or the plan terminates. Cash balance plans are often designed to operate for 10 years or longer, but can terminate early for reasons like the sale of the business."
Q. What Fees Are Charged for These Plans?
"A typical small firm might pay $3,000 to $5,000 to establish the plan, plus that amount or more in ongoing annual administration costs, depending upon the number of participants and the features selected."
If you have any more questions on cash balance plans, please send me an email and I'd be happy to answer:
smulholland@mk-am.com