For year-end tax savings, a particular type of pension may be the right medicine
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With the end of the year approaching and the possibility of tax hikes in 2022 looming, many physicians and their practices are looking at ways to reduce 2021 taxable income.
Implementing a particular type of pension plan will certainly work well for certain practices, but not all. It can also often be used with a physician’s ancillary income gained through moonlighting or outside work. If done right, this tool can provide significant tax relief, not only in 2021, but for all years in which it is in place.
In this article, we discuss the type of pension plan called a cash balance plan (CBP).
Cash balance plans: “Innovative pensions”
We refer to CBPs as “innovative pensions” because their use has grown rapidly in closely held businesses, including medical practices, during recent years. CBPs are a type of qualified retirement plan (QRP) for high income practice owners looking for tools that can provide them with significant short-term tax deductions along with strong long-term economics.
In a CBP, a participating employee will have access to a certain sum upon reaching retirement. Let’s use $100,000 as an example. To get to $100,000 at retirement, the plan assumes a combination of employer contributions and compound interest over time. When the employee retires, he or she can take the $100,000 either as a lump sum, or as an annuity that pays a portion of the $100,000 in periodic payments.
CBPs: The basics
CBPs are like traditional pension plans in terms of the funding and reporting requirements. Minimum funding standards apply; there is a minimum annual employer contribution that is reported on tax form 5500 for the CBP. An actuary is required to calculate this contribution amount using a reasonable actuarial funding method and actuarial assumptions specified by the IRS. 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 in order 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, since it is a specific amount. Owners and employees both know what is going into the plan on their behalf, and what will come out when the employee leaves.
CBPs work well with 401(k)s
CBPs are not mutually exclusive to 401(k)s, which many medical practices already have in place. In fact, a practice can typically utilize both types of plans simultaneously, “layering” a CBP on top of their existing 401(k) plan.
Four strengths of CBPs
There are four compelling reasons why medical practices are interested in CBPs:
Significantly increased deductions for plan contributions
In 2021, 401(k)s are subject to maximum deductible contribution limits of $19,500, with profit-sharing plan limits at $58,000. (The catch-up contribution for those over age 50 is an additional $6,500 annually.) 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.
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) plans and/or profit-sharing plans. Nonetheless, the tax savings typically dwarf these additional expenses, making the CBP extremely attractive.
Possible second level of tax deduction
For those whose income puts them above the tax code’s recent qualified business income (QBI) threshold limits, CBPs can be a tool to reduce taxable income enough to qualify for the QBI deduction, creating one deduction that leads to a second deduction.
Greater access to top (+5) asset protection level
As an exempt asset under federal law and most state laws, ERISA-qualified QRPs are protected at the highest (+5) level. Unless a CBP is put in place 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.
Conclusion
CBPs are powerful planning tools that can help an orthopedist reduce taxable income in 2021 and beyond. CBPs can be attractive to those who are looking for greater tax deductions, asset protection and superior retirement savings.
For more information:
Wealth Planning for the Modern Physician and Wealth Management Made Simple are available free in print or by ebook download by texting HEALIO to 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
Sanjeev Bhatia, MD, is an orthopedic sports medicine surgeon at Northwestern Medicine in Warrenville, Illinois. He can be reached at sanjeevbhatia1@gmail.com or @DrBhatiaOrtho.
David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group www.ojmgroup.com, where Jason M. O’Dell, MS, CWM, is the managing partner. They can be reached at 877-656-4362 or mandell@ojmgroup.com.
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