Cash Balance Plans: Defined Benefit Plans That Offer Greater Potential Tax Savings

Most aesthetic physicians are on the lookout for ways to reduce taxes and build retirement wealth. A Cash Balance Plan (CBP), a type of defined benefit Qualified Retirement Plan (QRP), may be an ideal tool to achieve both planning goals.

HOW CBPs ARE SIMILAR TO AND DIFFERENT FROM TRADITIONAL DEFINED BENEFIT PLANS

CBPs are similar to traditional defined benefit plans in terms of the funding and reporting requirements. Minimum funding standards apply; there is a minimum annual employer contribution that is reported on the CBP’s tax form 5500. An actuary is required to calculate this contribution amount using a reasonable actuarial funding method and actuarial assumptions specified by the Internal Revenue Service. The employer can decide to contribute an amount between the minimum funding requirement and the maximum permitted deduction but should attempt to fund to the actuary’s recommended contribution level to meet the plan’s current benefit liability.

On the other hand, CBPs are different from traditional defined benefit plans that promise a specified monthly benefit amount at retirement (ie, 3% of pay per year of employment, payable at the retirement age of 67). CBPs define benefits in the form of an account balance, rather than a periodic amount. This can be helpful because employees always understand what they are entitled to under the CBP, because it is a specific amount. Owners and employees know what is going into the plan on their behalf and what will come out when they leave.

BENEFITS OF CBPs

There are five compelling reasons why aesthetic practices are interested in CBPs:

1. CBPs work well with 401(k)s

CBPs are not mutually exclusive to 401(k)s. An aesthetic practice can typically use both types of plans simultaneously by “layering” a CBP on top of an existing 401(k).

2. Significantly increased deductions for plan contributions

In 2023, 401(k)s are subject to maximum deductible contribution limits of $22,500, with profit-sharing plan limits at $66,000. These limits will increase slightly each year. Properly structured CBPs, on the other hand, can allow business owners to make tax-deductible contributions of $200,000 or more, potentially saving them $80,000 to more than $100,000 in income taxes annually.

3. Additional costs are much less than additional tax savings

CBPs usually involve higher annual administration costs and higher employer contribution amounts for employees than 401(k)s and/or profit-sharing plans. Nonetheless, the tax savings typically dwarf these additional expenses, making the CBP extremely attractive.

4. Greater access to top (+5) asset protection level

As an exempt asset under federal law and most state laws, Employee Retirement Income Security Act of 1974 (ERISA)-qualified QRPs are protected at the highest (+5) level. Unless a CBP is for only one owner, with no other employees, this ERISA protection will usually also apply to the CBP. With larger contribution levels allowed in the CBP, this means more wealth can be protected in the CBP than in most other QRPs.

5. Possible second level of tax deduction

For individuals whose income puts them above the tax code’s qualified business income (QBI) threshold limits, CBPs can be tools to reduce taxable income enough to qualify for the QBI deduction even if a taxpayer’s business is a specified service trade or business, such as a medical practice. In this way, the CBP can create one deduction that leads to a second deduction. Please see the following example:

Conclusion

CBPs are powerful planning tools that provide larger contributions than the QRPs that most medical practices use today. CBPs can be attractive to practice owners who are looking for greater tax deductions, asset protection, and superior retirement savings.

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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice, or as a recommendation of any particular security or strategy. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.