Scenario: A Small Practice Considers a Cash Balance Plan

This page describes a composite hypothetical. It is not a real client or a real result. All amounts are assumptions, and plan design requires an actuary, so nothing here is a quote.

The Scenario in Brief

The owner of a small dental practice is 55 years old and wants to save more for retirement than a 401(k) plan allows. The practice has two employees. The owner has heard that cash balance plans can allow larger contributions and asks an advisor to help evaluate whether one could make sense.

Assumptions Used

• The owner has stable practice profit and expects it to continue for at least five years.
• An actuary's preliminary illustration, assumed for this scenario, shows an annual pay credit for the owner of 120,000 dollars.
• The two employees have combined pay of 150,000 dollars and are assumed eligible for the plan.
• To satisfy testing, the plan design provides employees a pay credit of 5 percent of pay, and the practice adds a 401(k) profit sharing contribution of 3 percent of staff pay.
• Annual actuarial and administration fees are assumed at 5,000 dollars.
• An assumed marginal federal rate of 32 percent is used for illustration.

Worked Arithmetic: What the Plan Might Cost

The deduction for plan contributions would generally be available to the practice, and the fees may also be deductible. At an assumed 32 percent rate, a deduction of 132,000 dollars in contributions would reduce federal tax by about 42,240 dollars, arithmetic that assumes the contributions are fully deductible and the owner has sufficient income. The 4,500 dollars of profit sharing and 7,500 dollars of employee pay credits are part of the cost of covering the staff. The owner would consider whether the total cost is worth the benefit.

What the Advisor Would Ask

The advisor would ask several questions before recommending that the owner take the next step. How stable is practice income? Would the practice remain able to fund the plan if revenue dropped by a quarter? How long does the owner expect to keep working? Does the owner plan to sell the practice, and how would a buyer view the plan? Are the employees likely to remain? Do the employees have ownership or family ties to the owner?

The Funding Commitment

Cash balance plans are defined benefit plans, so the practice must generally make the required contributions each year, as determined by an actuary. If practice income falls, the owner might need to reduce or freeze the plan, which is permitted within limits but should not be counted on. The plan's assumed interest crediting rate and its investment policy also affect required funding. The advisor would suggest that the owner consider a design that could be sustained in a downturn.

Exit Planning

The advisor would ask how the plan would end. If the owner retires or sells, the plan might be terminated, with the owner's account balance rolled over into an individual retirement account and employees' balances distributed or rolled over. Plan termination has rules and costs. The owner might also want to consider whether a buyer would be willing to assume the plan.

Alternatives

The advisor would explain alternatives, including a solo-style 401(k) with profit sharing, which may be adequate if the owner's goals are lower, or a SEP IRA, which could be simpler but would require the same percentage contribution for staff. The advisor would recommend obtaining illustrations from a plan administrator or actuary for several designs.

Scenario Variations Worth Considering

If the practice had ten employees, the cost of covering staff would likely be higher. If the owner were 45, the potential owner credit could be smaller. If the practice's profit were volatile, a smaller plan or no plan might make sense. If the employees were older, the cost of their credits could differ.

Risks and Limits

• Required funding can strain cash flow.
• Employee costs can be significant.
• Plan design and rules are technical.
• Numbers here are illustrative.

What This Scenario Teaches

A cash balance plan can be a way to save more, but it comes with a commitment and a cost for employees. Modeling the total cost, and testing a downturn, is essential.

Questions to Bring to Your Advisor

1. What is the range of the owner's contribution at my age and income?
2. What will covering employees cost?
3. What happens if income falls?
4. How would the plan be terminated?

Educational purposes only. This page is an illustrative educational scenario, not tax, legal, or accounting advice, and it does not describe a real client or a real result. Tax laws change and outcomes depend on individual facts, so consult a qualified professional before acting. No result is guaranteed.