Tuesday, February 22nd, 2022 | by Alan C. Hill, CPA and Lauren Holt, CPA
Need to Catch up on Your Dental Retirement Savings? Here’s One Way.
Dentists are increasingly getting a late start on saving for retirement. This is often because they are paying down school debt, financing a practice purchase, and so many other life/business matters. However, there’s a way to catch up these dental retirement savings, and even help to supplement the proceeds from a future sale of a practice – the Cash Balance Plan (CBP).
Set up a Cash Balance Plan
Different from the well-known 401(k) plan, the CBP is a type of defined benefit retirement plan that allows for significant annual contributions over $100,000 annually for the owner.
As many already know, 401(k) plans are a powerful tool to shelter income, but they do have restrictions on the amount that can be sheltered in any given year. The maximum dollar amount any single participant can receive, in terms of an annual addition to the account, is $61,000 for 2022.
How a Cash Balance Plan Can Help Your Dental Retirement Savings
By utilizing a CBP, the contribution limits that constrain 401(k) contributions are avoided. Typically, this strategy will be most successful when the owners are highly compensated and generally older (ideally over age 50) and their employees are generally younger and paid less. There is no specific dollar limit for contributions to CBPs.
A CBP provides an annual allocation and interest credit defined in the plan document. CBP accounts are hypothetical accounts and the plan investments are trustee directed in a single pool of plan assets. The actual annual contribution amount is calculated by an actuary and is a range, with a specific maximum and minimum amount allowed by the Internal Revenue Code.
Sample Cash Balance Plan Statement:
Beginning cash balance = $100,000
Interest credit (5.5%) = $5,500
Cash balance allocation = $100,000
Ending cash balance = $205,500
Beginning cash balance = $1,000
Interest credit (5.5%) = $55
Cash balance allocation = $1,000
Ending cash balance = $2,055
Maximize CBP Contributions for Your Dental Retirement Savings
Most commonly, Cash Balance Plans are paired with an existing 401(k) plan to maximize the efficiency of the combined plan allocations. A common plan design for eligible staff is at least 5 percent of compensation in a safe harbor 401(k) plan, and 2.5 percent of compensation in the CBP. Vesting schedules can be applied to the profit sharing and CBP contributions.
A cash balance plan must be in place for a minimum of three years. The plan is funded by deferring a portion of the owner’s compensation in the form of tax-deductible contributions to the plan. If you forego a $100,000 bonus and redirect it to a CBP, you receive current income tax savings of $40,000. Put another way, saving $100,000 in a CBP only costs you about $60,000 after taxes. When the plan assets are paid out in retirement (spread out over many years) you will likely be in a lower tax bracket – after you have received the payments from the sale of your practice.
Depending on your age and years of participation in the plan, you could accumulate approximately an additional $2.5 million in retirement wealth, based on current IRS regulations.
There are many benefits from setting up a CBP within a dental practice:
This significant increase in retirement savings can take the pressure off receiving the perceived full FMV (Fair Market Value) for the sale of your practice. Oftentimes, a dentist feels pressured to work a full schedule through retirement to maximize the practice’s FMV. While working hard right up to the finish line does help to maximize the value of the practice, what if you just can’t?
What is often overlooked is the ability to be able to rely on the cash balance plan as an additional retirement income source, rather than just relying on the funds from the practice sale and defined contribution retirement accounts, such as a 401(k) plan. It’s the old adage of not putting all your eggs in one basket, diversification; always be ready for anything.
If you do make it to the finish line at full steam, you haven’t lost the value of the practice. In fact, you have gained more tax deferred money to grow in a retirement account.
It can also hedge against other unforeseen circumstances, like death or disability. If a dentist cannot work in a practice due to disability, the practice will take time to sell and the value decreases quickly, leaving less for your family and loved ones. The assets in a CBP can add to the security of existing disability and life insurance policies.
The use of a CBP can also be used in negotiating a sale to a current associate. By working through a production-based model for compensation, and having a younger associate opt out of the plan, the extra contributions made to the CBP plan can be used toward an ownership transition plan. The services of a qualified healthcare attorney and an experienced dental CPA are essential to doing this correctly, legally, and with no unintended tax consequences for either party. This specific strategy is too complex to cover fully in this article.
Cash balance retirement plans offer compelling advantages in the sale of a dental practice and significant income tax savings opportunities for transitioning dentists. They are not the only planning solution, but they certainly offer powerful tax savings potential.
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