Reduce Taxes and Boost Your Retirement Fund? Paul Danziger

For the dental practice owner, the retirement marketplace can be a crowded space, with many options and considerations to navigate. Some of these considerations include annual limits on retirement contributions, rate of return, tax deductibility and tax-free income. Determining key differences and trade-offs between retirement planning offerings can pose a particularly daunting challenge.

What if a dental practice owner could come up with a retirement planning strategy that allowed him or her to boost annual retirement contributions while slashing taxes? And, at the same time, deliver a predictable rate of return plus the possibility to structure a tax-free income stream? All of this is possible thanks to the powerful blend of life insurance and investment products that form a cash balance plan—a type of defined benefit plan.

Cash balance plan vs. traditional pension
A cash balance plan is a type of defined benefit plan, which guarantees a specified benefit or payout based on a predetermined formula. In a typical pension fund, such as a 401(k) plan, the amount of payouts depends on the return of the funds invested.

With a cash balance plan, the formula for calculating the plan participant's contribution is known ahead of time, and the plan guarantees a specific benefit or payout upon retirement.

According to an article by Kiplinger.com senior editor Eleanor Laise, "Many older business owners are turning to these plans to turbocharge their retirement savings. Cash balance plans have generous contribution limits that increase with age. People 60 and older can sock away well over $200,000 annually in pretax contributions. In 401(k)s, total employer and employee contributions for those 50 and older are limited to $57,500." Kiplinger is a publisher of business forecasts and personal financial advice.

How it works
The retirement-building advantages of a cash balance plan start with potentially larger tax deductions, thanks to higher allowable contribution limits. A second advantage is tax-deferred growth of plan contributions. A triple retirement win can be achieved when the life insurance component of the plan is structured to produce a future annual stream of tax-free income from the policy's cash value.

Unlike a 401(k) plan, which relies on individual contributions from each employee and can increase or decrease in value based on performance of investment vehicles in the plan, cash balance plan contributions are funded entirely from the owner(s) of the business. Performance of investment products within the plan is not of great concern because there is a predetermined rate (usually 5–6 percent.)

How does a cash balance plan supercharge retirement savings? The first way is through the annual contribution amount, which can be far greater than 401(k) contribution limits. The second way is through the potentially significant tax savings that can be claimed by the practice owner(s) when adjusted gross income is reduced by plan contributions. With this one-two punch, the practice owner's taxes can decrease substantially compared to a 401(k) plan.

Unlike other defined benefit plans, a cash balance plan has more flexibility. If a dental practice has unexpected expenses, or there is a decline in business revenue, the plan owner has the option to put in less money.

Who is it for?
Cash balance plans work best for dental practice owners who want at least $60,000 a year in tax deductions. In addition, these plans are particularly advantageous for dentists age 50 or older, because they are likely to have the means to make larger plan contributions and, as a result, reap the greatest returns. When it comes to practice size, smaller is better because fewer employees means the owner keeps more of the money that goes into the plan and, of course, the resulting tax savings.

There are certain IRS non-discrimination testing requirements, which determine which employees must be included in a cash balance plan. Consult with your financial professional for more details.

Investment vehicles
In a cash balance plan, investment vehicles are usually in two categories: securities, such as stocks or mutual funds, and a whole life insurance policy that normally pays a guaranteed growth percentage (4–4.5 percent per year). The death benefit payable by the insurance policy is a key element of the plan, because in the event of the practice owner's death before the plan is fully funded, the life insurance proceeds would make up the difference in plan proceeds.

Another advantage of the life insurance component is that the cash value inside the life insurance policy can be used to create a stream of tax-free income in future years.

Step-by-step setup
1. An employee census is prepared. This census must include every employee, including the owner, and show each employee's date of birth, length of employment and income for the previous three years. This census is then provided to a third-party administrator (i.e., actuary), who performs an analysis that determines the contribution level for each employee participating in the plan.

2. You and your financial advisor then determine the investment vehicles that will be included in the plan, usually whole life insurance and conservative stocks.

3. Documentation required for the plan is completed. All plan documents must be signed by the end of calendar year in which tax deductions are claimed.

4. The plan is funded. The practice owner has until the tax payment deadline (including any extension) to make the first annual contribution.

5. Each year moving forward, the third-party administrator prepares annual documentation needed by the IRS. In addition, the practice owner and plan participants receive a statement showing how their individual plan contributions and value are growing.

Running the numbers
The annual contribution to a cash balance plan depends on the age of the dental practice owner and his or her income. Usually $250,000 is the recommended maximum. If the practice owner is five years from retirement, $250,000 each year in pretax contributions is a sure-fire way to catch up. By contrast, with a 401(k) plan, the practice owner would be limited to fraction of that amount.

Cash balance plans do come with administrative costs, most of them related to the time spent by the actuary in constructing the plan (which includes conducting the employee census), drawing up plan documents and preparing annual tax returns. The level of administrative costs corresponds to the number of employees participating in the plan. On average, set up charges run around $3,000 and annual administration fees are about the same amount.

Experts agree that for older, successful practice owners, the tax advantages of case balance plans far outweigh the costs if the contributions are done correctly.

On the investment portion of the cash balance plan, investment management fees range from 1–1.5 percent on assets. Some business owners who love the stock market and are able to reduce brokerage fees by handling their plan's stock investments personally.

Let's examine one real-world example in which a 48-year-old dental practice owner has $243,000 in annual income. He is contributing $18,000 a year to the practice's 401(k) plan. By setting up a cash balance plan to complement the 401(k)—this is perfectly allowable and one of the flexibility benefits of a cash balance plan—he can contribute $107,000 to the plan annually. Part of that contribution includes a $50,000 annual life insurance premium on a whole life policy that provides a $1 million death benefit.

Since the $107,000 plan contribution is pretax, the physician takes that amount off his taxable income. Moreover, since he is in the 40 percent tax bracket, he will save $42,800 in taxes each year.

Keep in mind
Maximizing investment returns is not the goal of a cash balance plan. Return on a 401(k) plan could be higher if stocks are doing well. Of course, with higher 401(k) returns comes greater risk.

A cash balance plan, by contrast, is all about predictable returns of 5–6 percent per year coupled with the additional advantages of tax deductibility.

Two strategic keys are lowering risk and keeping more money for yourself. At the same time, a cash balance plan allows the dental practice owner who needs to play catchup on his or her retirement savings to put retirement planning on a faster pace. The older the practice owner is, the more he or she can put into the plan.

Maintaining lifestyle is another retirement planning issue related to a cash balance plan. While it might seem like a good idea to pump up retirement savings, this should not be done at the expense of a business owner's lifestyle. For example, we are working with a business owner for whom the actuary established a maximum annual plan contribution of $150,000. But because the owner is shouldering college expenses, we decided to put in less. Having this flexibility to adjust plan contributions from year to year to reflect lifestyle changes is, in the long run, another huge benefit of a cash balance plan.

Key takeaways
For dental practice owners looking to supercharge retirement savings, a cash balance plan can be a smart way to go. The closer a person is to retirement, the more important it is to maximize savings. Compared to a 401(k) plan, a cash balance plan allows the practice owner to sock away much more money year to year. In addition to putting retirement savings on a fast track, a cash balance plan also enables the practice owner to enjoy substantial tax savings. Also, the plan assets in a cash balance plan are protected from creditor claims by ERISA (Employee Retirement Income Security Act).

A further benefit of a cash balance plan, in addition to saving large chunks of money for retirement, is that the life insurance component of the plan can be structured to produce a stream of income that is entirely tax-free.

Maximizing retirement savings. Ensuring a predictable return. Reducing taxes. Thanks to a cash balance plan, it all adds up to a triple win in retirement planning that helps dental practice owners keep more of their hard-earned wealth.

Note: Investment advisory services offered through Virtue Capital Management, LLC (VCM), a registered investment advisor. VCM and Freedom Financial Advisors of MD are independent of each other. Information provided is not intended as tax or legal advice, and should not be relied on as such. You are encouraged to seek tax or legal advice from an independent professional.

References
1. http://www.kiplinger.com/article/retirement/T047-C000-S004-the-pros-and-cons-of-cash-balance-plans.html

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