Design the Best Pension Strategy for Your Cash Flow: What Is a Cash Balance Defined Benefit Plan and How Do I know if One Is Right for Me?
Most of us are aware of the 401(k) plan and have some idea of how it works. In short, employees have the option each year of deferring a portion of their salary on a tax-deferred basis into a retirement account. Sometimes, the employer also will contribute funds into an employee’s retirement account based on a formula for matching such deferrals. The 401(k) plan is a Defined Contribution plan because only the contributions are regulated – not the future retirement benefits.
Long before the 401(k) plan, the classic employer-offered retirement plan was the Defined Benefit (DB) plan. As the name implies, an employer and sometimes the employee, the plan’s participant, fund over time a promised, defined retirement benefit. The best-known DB plan today is the Social Security retirement plan.
DB plans use a formula to calculate a future benefit for each participant, usually based on the participant’s pay and age, and translate that into an annual contribution. In most cases, younger participants require a lower annual contribution because there is a longer period until their retirement.
In general, DB plans are most advantageous for dental practices in which the dentist works with a small staff of younger employees. Using the DB funding formula, the dentist generally receives the largest share of the calculated annual contribution. This level of favorable funding is a key advantage of the DB plan.
Cash balance DB plans, which maintain a hypothetical individual account for each employee, often work best for dentists who consistently generate sufficient cash flows to fund the annual required contributions. Unlike 401(k) plans, there is typically not much flexibility for an employer funding a DB plan, especially in its first few years. Consequently, without a consistent level of annual cash flows from your practice, a DB plan generally isn’t recommended.
In some cases, dentists have sufficient cash flow to fund both a 401(k) plan and a cash balance DB plan. This is a significant opportunity for the practice owner to maximize tax-deferred retirement savings.
A word of caution when contemplating a cash balance DB plan – it is best to work with an experienced and competent pension actuary. Some companies offering these plans lack the expertise to maximize the practice owner’s share of contributions while still complying with current pension rules.
This commentary originally appeared June 6 on DentalTown.com
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