A complementary retirement plan with potential tax savings.
By Adam Cmejla, CFP®
Dec. 6, 2023
One of the benefits of owning your own practice is the ability to have more control over your cash flow. As I’ve often said on episodes of my podcast, 20/20 Money, and in my past articles for this publication, all of financial planning comes down to the organization and prioritization of cash flow. This philosophy applies to both personal and professional financial planning, and when done purposefully and in coordination with one another, it can allow you to utilize a very specific planning vehicle that provides a multitude of benefits to you and your team: the defined benefit (DB) plan.
Specifically, we’ll discuss what a DB plan is, when a practice is likely primed and ready to consider implementing one and the variety of benefits that exist when implemented. Lastly, I’ll include a hypothetical example of a practice that’s a good fit for a DB plan and illustrate the benefits—now and later—of implementing such a plan, along with a tax planning strategy for a practice owner to consider.
What is a Defined Benefit Plan?
A defined benefit plan is a type of qualified retirement plan that will essentially “sit on top” and complement any existing qualified defined contribution retirement plan (DC plan) that exists in the practice. The most common type of DC that practice owners would already have implemented in their practice is the 401(k) profit sharing plan.
A defined benefit plan requires many different parties to advise and manage the plan in accordance with the plan’s adoption agreement. It requires a third-party administrator (TPA) to be the accountant for the plan. A TPA’s job is to track the plan’s allocation of contributions to the eligible participants, performing the annual testing requirements as requirement by the IRS and Department of Labor to ensure compliance and conformance to the rules, and also files the equivalent of the plan’s annual tax return. The best-case scenario is when the TPA involved is doing the annual compliance management for both the DB and DC plans in the practice. It increases the efficiency for all parties involved— ensuring that the left hand knows what the right hand is doing.
It also requires prudent investment management to conform to the crediting rate of the plan—it’s not just a matter of allocating the investments into a target date retirement fund or an S&P 500 index fund.
When is a Practice Potentially Ready for Defined Benefit Plan?
I consider defined benefit plans to be the most “mature” plan that a practice owner could implement. By mature I mean it’s a plan that is implemented in a practice with healthy, predictable cash flow. The practice also usually has minimal debt on the balance sheet, and even if the practice does have current debt or anticipates taking on future debt on the balance sheet, the cash flow is still healthy enough to support the allocation of cash flow into a DB plan.
It also works best when there is a decent delta between the average age of the “rank and file” employees (non-highly compensated) and the owner. This isn’t an absolute must-have variable, but why this is the case is best demonstrated by looking at the plan illustration at the end of this article (but don’t skip ahead!).
What are the Benefits of a Defined-Benefit Plan?
Simply put, the biggest advantage to a DB plan for a practice owner is the ability to enact “tax arbitrage” within their own personal financial plan while also rewarding their team members for their loyalty to the practice.
Here’s how tax arbitrage works: absent any tax sheltering from retirement plans, any net income that an optometry practice earns is passed through to the owner(s) of the practice and taxed at their own individual tax rate (S-corps, sole proprietors or partnerships) or it is taxed at the corporate level of 21 percent, only to be taxed again if it is passed through to the owners as a dividend if the practice is set up as a C-corporation. (Given that most practices are taxed as pass-through entities like S-corps, sole proprietorships, partnerships or LLCs, that elect to be taxed as pass-through entities, the remainder of this article will discuss from this point of view).
This means that a highly efficient, highly profitable practice may be generating profits that are being taxed at a high personal income tax rate of either 35 percent or 37 percent (the top two tax rates in 2023, the year this article is being written).
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If the owner(s) of the practice doesn’t need that business income to sustain their personal quality of life, they’re essentially being forced to pay taxes on those dollars in each tax year.
But because contributions into defined benefit plan, like a cash balance plan, are made on a pre-tax basis, these contributions essentially defer the tax liability to a point in the future when the owner is (likely) in a lower tax bracket. The owner is making the proactive decision to shelter dollars inside of a vehicle within the practice with the intention of paying taxes on those dollars at some point in the future and at a lower rate, thus arbitraging the amount of money they’d pay in taxes.
A Hypothetical Example
Here’s a typical timeline that can play out for a practice owner who is about five years from selling their highly profitable, highly efficient practice, and is looking to minimize the total amount in taxes they pay on the profits of their practice.
Let’s say the practice owner has an extra $200,000 of net income that the practice generated that the owner doesn’t “need” to sustain their normal quality of life. Said differently, all that would happen with this money absent any proactive planning is that it’ll end up in either a brokerage, saving, or some other investment account.
If, however, the practice owner worked with their advisory team and implemented a type of DB plan called a cash balance (CB) plan into the practice, and the owner wanted to retain the same $200,000, here’s how those contributions would be allocated among the owner and team members:
Notice the second column from the right. In order for the owner to retain $200,000 for themselves, they only needed to contribute $201,100! This means that they retained 99.45 percent of the cash balance contribution!
Sure, the owner had to make non-elective match contributions into the 401(k), which is reflected in the Safe Harbor column above. But even with those total non-owner contributions of $5,400, that’s still only a 2.7 percent “tax” to be able to shelter $200,000 of their own profits inside of the plan!!
(Note: you need not be concerned with how the owner-to-employee contribution ratios are calculated. This is the responsibility of your TPA and are beyond the scope of this article).
The rest of the story…
Now, if you thought that was good, wait till we see “the rest of the story” (as Paul Harvey would say). What happens after our owner sells their practice?
Let’s assume our practice owner made several similar contributions over the next five years and ended up with $800,000 in their cash balance plan and that, during those five years, these dollars would have otherwise been taxed at their ordinary income tax rate of 35 percent. That means their net would have been $520,000 after paying the tax bill of $280,000.
Once our practice owner sells their practice in the fifth year, their post-sale personal income could essentially be zero. This is quite possible if they don’t have any other sources of income and haven’t elected to start Social Security.
Enter Roth Conversions.
Through collaboration and proactive planning, we would now work with our former-owner-now-retiree to convert the cash balance plan into Roth IRA dollars through a series of systematic Roth conversions. Since there’s no limit on the amount that one can CONVERT to a Roth IRA, we have flexibility in how we approach this strategy.
Let’s say that we collectively agree to proceed with Roth conversions up to the 22 percent tax bracket. Assuming our OD is married, filing jointly and has no other income, this would equate to a roughly $218,000 conversion amount (after taking the standard deduction into consideration). At a 22 percent tax rate, this Roth conversion generated a tax bill of $32,481. This makes the effective tax rate of this conversion to be 14.9 percent, which generated a tax savings of $43,819 compared to paying 35 percent ($76,300) in taxes had our owner not used a cash balance plan!
With each passing year, we would proactively evaluate the entirety of the plan and determine if, or to what extent, we would continue with the Roth conversion strategy.
This strategy is just one of many I have written about that illustrate the benefit of control that exists when practice owners are proactive, intentional, and collaborative with their advisory team. The sooner you decide to act, the more beneficial strategies like this can be for you, your family and your team.
Adam Cmejla, CFP® is a CERTIFIED FINANCIAL PLANNERTM Practitioner and Founder of Integrated Planning & Wealth Management, LLC, an independent financial planning & investment management firm focused on working with optometrists to help them reach their full potential and achieve clarity and confidence in all aspects of life. For a number of free resources, visit https://integratedpwm.com/ and check out the “20/20 Money Podcast” to get more tips on making educated and informed financial and business decisions.