As a small business owner or a physician running your own practice, you probably spend most of your time focused on advancing your career. Retirement can sometimes feel too far out to plan for; yet the sooner you start, the easier it will be to ensure you have enough assets to retire on your own terms.
As a physician or small business owner, there are several different types of retirement account options you can utilize. Each has its pros and cons. Today, we’ll explain why cash balance plans are becoming a popular retirement account choice for high-income earners, like physicians and small business owners, who want to supercharge their retirement savings.
We’ll define what a cash balance plan is, how it works, and how it’s different from other types of retirement plans so you can decide whether it’s something worth exploring for your financial plan and for your business.
What is a cash balance plan? And how does it work?
A cash balance plan is a specific type of retirement planning tool that combines elements of a defined benefit plan and a defined contribution plan. Like traditional pension plans, cash balance plans promise a fixed benefit upon retirement.
However, each participant in a cash balance plan has an individual "account" that shows their accrued benefits in the form of a balance. Note that this balance is only hypothetical — it's not actually an account holding investments like in a 401(k). Instead, the employer guarantees a certain contribution (often a percentage of salary) and a guaranteed interest credit.
For example, let’s say you're a small business owner earning $300,000 a year. With a cash balance plan, you decide to contribute 5% of your salary annually. This means each year, $15,000 (5% of $300,000) is credited to your account. Additionally, the plan offers a fixed interest rate of 4%, so at the end of the year, you'd also earn $600 in interest (4% of $15,000), bringing your total account balance to $15,600 for that year.
Employee eligibility for a cash balance plan
Whether you’re the sole employee in your business or if you have other employees, eligibility for a cash balance plan usually includes meeting minimum age (typically 21) and service requirements (often one year). Both full-time and part-time employees can participate, though benefits for part-timers may be pro-rated.
Employers must also comply with IRS nondiscrimination rules, ensuring the plan is fairly offered to employees at all income levels. While employers have flexibility in setting criteria, once eligible, employees start receiving contributions and interest credits according to the plan’s terms.
Comparing cash balance plans with other retirement plans
Cash balance plans vs. defined benefit pension plans
First, let’s take a look at how a cash balance plan is different from traditional defined benefit pension plans. Traditional pension plans calculate your retirement benefits based on three main factors:
- years of service, which increases your benefit the longer you work for the employer;
- final average salary, usually the average of your highest-earning years;
- and a benefit multiplier, a percentage that is applied to your years of service and salary.
These factors combine to determine the annual payout you'll receive in retirement, typically as a lifetime monthly income.
In contrast, in a cash balance plan, the employer credits a set percentage of an employee’s salary annually, along with a fixed or variable interest rate (the crediting rate), creating a hypothetical account balance that's easier for employees to understand.
When setting up a cash balance plan for your business, you, as the employer, have the flexibility to determine this crediting rate based on a percentage of your employees’ annual salary or a fixed dollar amount. You can set it at a level that works best for your business’s financial goals, but it often ranges between 5% and 8%.
Additionally, you’ll decide whether to offer a fixed or variable interest rate on these contributions. A fixed rate gives you predictability, ensuring that employees earn a steady return each year, while a variable rate may fluctuate, usually tied to an index like Treasury bond rates.
Cash balance plans vs. 401(k)s and other defined contribution plans
A 401(k) is one of the most popular retirement savings options, offering employees and business owners flexibility and control over how their money is invested. However, it’s not the only defined contribution plan available. Plans like the 403(b), designed for nonprofit and public sector employees, the 457(b) for government workers, and the SIMPLE IRA or SEP IRA for small business owners, all provide tax-deferred ways to save for retirement.
The investments within each of these plans are typically controlled by the employee or plan participant who consequently bears the investment risk. With a cash balance plan, however, the employer (or you as the business owner) takes on the investment risk. Regardless of how the market behaves, your cash balance pension account is guaranteed to receive the promised interest credit each year.
Additionally, cash balance plans offer higher contribution limits, making them particularly appealing for high-income earners. Please see the IRS.gov website for the current contribution limits.
Pros and cons of cash balance plans
Some of the main benefits of cash balance plans include their high contribution limits compared to other retirement plan options, their tax-deferred status, and their flexibility.
Advantages of cash balance plans
- Tax-deferred growth: Your contributions and investment returns in a cash balance plan grow tax-deferred, meaning you won’t owe taxes until you begin withdrawing funds in retirement. For doctors and business owners who may be in a lower tax bracket at retirement, this tax deferral can result in significant savings.
- Higher contribution limits: The contribution limits for cash balance plans are not fixed like those of a 401(k). Instead, they are tailored based on your income, age, and desired retirement balance.
- Portability: Cash balance plans are portable. If you decide to change jobs, you can take the vested portion of your plan and roll it into an IRA or another retirement account.
- Flexibility in retirement: When it comes time to retire, you’ll have the option to take a lump sum payout if you want access to the money (for example, to reinvest elsewhere). You can also choose to receive your benefit as an annuity that provides you with a consistent monthly income.
Next, here are some things to consider if choosing a cash balance plan as your retirement plan option.
Disadvantages of cash balance plans
- Higher admin costs: Cash balance plans require actuarial services to ensure they are adequately funded. This can mean higher administrative costs compared to other retirement plans.
- No employee contributions: If you have employees, they cannot contribute to the cash balance plan from their salaries. As the employer, you are responsible for contributing to the plan. You can, however, deduct the contribution to the plan as a business expense.
Tailoring cash balance plans for physicians and small business owners
Why cash balance plans are ideal for physicians
As a physician, you’re likely earning a high income and may be looking for ways to save on taxes now while maximizing your retirement savings with a tax-deferred account. A cash balance plan allows you to do just that, providing higher contribution limits than typical retirement accounts.
Since physicians often face long working hours and don’t always have the time to manage their own investments, it may be a good idea to let professionals handle the investments in the plan.
Advantages of cash balance plans for small business owners
For small business owners, a cash balance plan is an attractive tool to help you save for retirement while offering a competitive retirement benefit to employees. It allows you to create a tax-deferred savings plan that can significantly reduce your taxable income each year.
In addition, setting up a cash balance plan helps you attract and retain top talent. By offering a retirement plan that’s more robust than a simple 401(k), you’ll have an edge when competing for the best employees.
Key considerations for implementing a cash balance plan in your practice or business
If you’re looking for higher contribution limits, tax savings, and professional management of your retirement funds, a cash balance plan could be an excellent fit for both physicians and small business owners.
Consistent contributions into the plan, combined with compounding interest and tax-deferred growth, can help you build a sizable retirement nest egg. Whether you're planning to exit your medical practice or wind down your business, a well-funded cash balance plan can help secure your financial future.
As a physician or business owner, your time is precious, and managing complex retirement plans can be challenging. That’s where having a good financial advisor can be helpful and save you time and money. A financial advisor who works with business owners can guide you through the process of setting up and maintaining a cash balance plan, ensuring that it aligns with your long-term goals.
If you’re ready to explore how a cash balance plan can benefit your retirement strategy, you can schedule an appointment with one of our financial advisors here.
