Cash Balance vs. Taxable

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Topic Author
uvadk
Posts: 57
Joined: Wed Oct 26, 2011 8:55 pm

Cash Balance vs. Taxable

Post by uvadk »

All,

My wife and I are considering investing in her group's new cash balance plan in addition to the current taxable investing we have been doing.

A little background:
-Maxing out his 401k/profit sharing plan ($53k)
-Maxing out her 401k ($17k)
-Maxing out his HSA
-Established and funded 529s for 2 yr old son and soon to be born daughter
-Remainder has been invested in taxable Vanguard account (60% VTSAX, 25% VTIAX, 15% VWIUX)

Tax brackets:
39.6% fed
6% state

She is a highly compensated employee in a medical practice and now has the option to invest in their cash balance plan. It looks like we would be able to invest around $50-60k in this plan at an assumed interest rate of 3%. We would still have more to invest in the taxable account on top of that.

Question: Does it make sense to go ahead and invest in the cash balance plan at the assumed 3% interest rate? Do the numbers still make sense vs taxable investing at a predicted 5,6, or 7% real return?

Appreciate the advice!
DK
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FiIQ
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Re: Cash Balance vs. Taxable

Post by FiIQ »

uvadk wrote:Question: Does it make sense to go ahead and invest in the cash balance plan at the assumed 3% interest rate? Do the numbers still make sense vs taxable investing at a predicted 5,6, or 7% real return?

If you can remove market risk and actually achieve 3%, it sounds pretty good to me....

What is the risk profile/guaranties of that plan, is the rate fixed? What are the terms, are they providing any type of match?


Edit: This might be of interest to you http://www.dol.gov/ebsa/faqs/faq_consum ... plans.html
Topic Author
uvadk
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Joined: Wed Oct 26, 2011 8:55 pm

Re: Cash Balance vs. Taxable

Post by uvadk »

FiIQ,

Thanks for the reply.

The plan is 20% equity/80% bond - I am in the process of finding out the assets held, thought I believe they are all DFA.

Yes - it does sound appealing as she is an employee and does not bear the market risk of the plan.

No match. This is only deferred compensation from her income.

Admin fees are being paid by the group.

However, investment fees (as well as fund eep ratios of approx 20 bps) are paid out of the plan according to this scale:

Assets Under Management Annual Management Fee

Up to $500,000 0.85%
On the next $250,000 0.80%
On the next $4,250.000 0.50%
On the next $5,000,000 0.35%
Over $10,000.000 0.25%

Thoughts?

DK
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FiIQ
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Re: Cash Balance vs. Taxable

Post by FiIQ »

uvadk wrote: However, investment fees (as well as fund eep ratios of approx 20 bps) are paid out of the plan according to this scale:

Assets Under Management Annual Management Fee

Up to $500,000 0.85%
On the next $250,000 0.80%
On the next $4,250.000 0.50%
On the next $5,000,000 0.35%
Over $10,000.000 0.25%
Ok, few more things.

How much do you/your wife think is actually in the plan?

You said "highly compensated employee" (I read this as, not the norm) and you're potential dropping 50-60K in this plan. It would take 10 others doing the same to hit the first hurdle.

So, let's say .85% + .20% (the 20bps) = 1.05. With that knowledge you are getting less then 2% (3-1.05) and are probably better investing the cash on your own, maybe a muni bond fund.

Edit: removed suggestion.
Topic Author
uvadk
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Joined: Wed Oct 26, 2011 8:55 pm

Re: Cash Balance vs. Taxable

Post by uvadk »

Great point. Have emailed the plan advisor to ask that very question. Do not know how much AUM at this time, but would guess under that first threshold.

Assuming <$500k in fund currently, that would give the 1.95% interest as you showed. Would taxable investing (even at 45% fed/state) still make more sense?

DK
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FiIQ
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Re: Cash Balance vs. Taxable

Post by FiIQ »

uvadk wrote:Would taxable investing (even at 45% fed/state) still make more sense?
I would say it's all about risk tolerance...

If you are comfortable with market risk, yes. Remember, you are never forced to sell while you are in the higher tax bracket.

If you are looking for that elusive "risk free return" and 1.95% is the worst you can do it's probably a wash. A tax exempt bond fund yields 1.6% +/- (you will lose .35 vs. your wife's plan/option) and you could have state taxes to pay. The upside to this option, for .35 you will have control over the funds and can shift, when a better opportunity presents itself.
RNJ
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Re: Cash Balance vs. Taxable

Post by RNJ »

Make sure you really understand what a cash balance plan is. That 3% is not guaranteed (how could it be with a 20/80 allocation?). Rather, it is a "collar" on returns. If the plan outperforms the collar, your contribution is/may be reduced the following year(s). If the plan underperforms, your contributions (may) rise.

Also, you need to understand what your base contributions will be going forward.

We are similarly positioned tax-wise, and we've been participating in my wife's plan since inception (3 years) at currently ~ 5% of income.

Good luck.
Topic Author
uvadk
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Joined: Wed Oct 26, 2011 8:55 pm

Re: Cash Balance vs. Taxable

Post by uvadk »

RNJ, thanks for the info.

My understanding of a cash balance plan is that there is a difference for the owners of the company vs. the employees. In other words, the owners (in this case the practice partners) are responsible for funding any underperforming years (just as they may decrease their contributions for over performing years).

Is this not correct? Will my wife as an employee have a similar contribution requirement in good/bad years?

DK
Topic Author
uvadk
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Re: Cash Balance vs. Taxable

Post by uvadk »

Just found out that AUM are currently $135k, so well under the $500k threshold for 0.85% fees.

Though the advisor claims the fees do not affect the interest rate, it is my understanding that these fees are paid out of the plan - so they are effectively decreasing the assumed return.
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Toons
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Re: Cash Balance vs. Taxable

Post by Toons »

"However, investment fees (as well as fund eep ratios of approx 20 bps)"



Given the stability and amount of your income ,
I would avoid those fees at all cost and continue with taxable investing.
3% and fees year after year,,,just wouldn't appeal to me. :happy
"One does not accumulate but eliminate. It is not daily increase but daily decrease. The height of cultivation always runs to simplicity" –Bruce Lee
Topic Author
uvadk
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Re: Cash Balance vs. Taxable

Post by uvadk »

Toons,

I have been hesitant to get involved with the plan for just that reason.

Any other thoughts out there as to whether or not we should invest in the cash balance plan?
leadeyes
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Joined: Fri Jan 29, 2016 5:52 pm

Re: Cash Balance vs. Taxable

Post by leadeyes »

I have a cash balance plan with my work. However, I am embarrassed to say that I know substantially less regarding its logistics and operations

The main reason that I invested in the plan was because I am in the same tax bracket as you. The plan seemed preferable to giving 40% of my income in taxes to the govt. Moreover, once you leave the group, are you eligible to move This money over into an individual retirement account?
orthodoc
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Re: Cash Balance vs. Taxable

Post by orthodoc »

I am currently setting up a CB plan for my office. We are able to defer closer to 100k a year, increasing as we age and are pairing it with a current PSP and 401k. Our tax rate is identical to yours and you have to consider the 1.8% Medicare surtax. The return is gauranteed by the plan and the investments are pooled in a single account. Each participant has an account balance that is credited each year by the assumed rate. The fees are not insignificant but the tax deferral is worth it to us. I am not sure how it works when employees have optional deferrals like you are describing, but we are obligated to fund at a prescribed rate based on our plan document. The odd nature of the account is you want to get the "rate" you guarantee and if you fall short it is made up by contributions made by the owners. Your account balance is "gauranteed " as a participant and risk is taken by the owners. Therefore the investments tend to be conservative not looking to outperform the gauranteed rate. If you earn a higher rate it goes towards next years contributions and decreases the amount that can be contributed, limiting the amount that can be added the next year. It is more of a tax shelter that can be rolled into an IRA upon separation, retirement or closing of the plan.
Personally as an employee I would take full advantage of it thinking of it as a large IRA with a bond gaurenteed to get 3%. I would consider it as your bond allocation. While there are risks if the group has financial difficulties, I would think as an employed Dr. She would have a good idea on the health of the group.

Just my two cent, going through the process currently, I thought I might ad perspective.
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alec
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Re: Cash Balance vs. Taxable

Post by alec »

orthodoc wrote:I am currently setting up a CB plan for my office. We are able to defer closer to 100k a year, increasing as we age and are pairing it with a current PSP and 401k. Our tax rate is identical to yours and you have to consider the 1.8% Medicare surtax. The return is gauranteed by the plan and the investments are pooled in a single account. Each participant has an account balance that is credited each year by the assumed rate. The fees are not insignificant but the tax deferral is worth it to us. I am not sure how it works when employees have optional deferrals like you are describing, but we are obligated to fund at a prescribed rate based on our plan document. The odd nature of the account is you want to get the "rate" you guarantee and if you fall short it is made up by contributions made by the owners. Your account balance is "gauranteed " as a participant and risk is taken by the owners. Therefore the investments tend to be conservative not looking to outperform the gauranteed rate. If you earn a higher rate it goes towards next years contributions and decreases the amount that can be contributed, limiting the amount that can be added the next year. It is more of a tax shelter that can be rolled into an IRA upon separation, retirement or closing of the plan.
Personally as an employee I would take full advantage of it thinking of it as a large IRA with a bond gaurenteed to get 3%. I would consider it as your bond allocation. While there are risks if the group has financial difficulties, I would think as an employed Dr. She would have a good idea on the health of the group.

Just my two cent, going through the process currently, I thought I might ad perspective.
to add to this, uvadk, you should get the Summary Plan Description (SPD) which should describe all the ins and outs of the plan - crediting rate (and how it works), contributions, etc. Another thing to check is if the plan is covered by the Pension Benefit Guarantee Corp (PBGC), in case the practice/company runs into financial hardships and the cash balance plan needs to be turned over to the PBGC.
"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" - Upton Sinclair
Topic Author
uvadk
Posts: 57
Joined: Wed Oct 26, 2011 8:55 pm

Re: Cash Balance vs. Taxable

Post by uvadk »

orthodoc and alec, thank you.

orthodoc - what you said makes sense. given the high fees associated with this plan (currently running approx 1.05% at current assets), would you still get involved? just want to be sure the tax deferral benefits outweigh the fees.

alec - I do have a copy of the plan summary and have read through it. Do not see any mention of the PBGC. would this be a deal breaker for you?

Thanks!
RNJ
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Re: Cash Balance vs. Taxable

Post by RNJ »

Orthodoc and Alec have it right. My wife is an owner so my understanding came from that perspective.

Given your tax rate, the plan still seems like a reasonable choice.
TheGipper
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Re: Cash Balance vs. Taxable

Post by TheGipper »

Bottom line is if you can afford it, defer as much money in as you can afford. Paying <20% effective tax when you withdraw in retirement beats the heck out of paying 46% tax now.

Be sure to budget for the catch up contributions. For example if you contribute 100k/yr and the market tanks you could on the hook for another 50k to catch up. Make sure you have the cash flow.

Make sure your plan is continually enforcing the catch up provisions rather than running a deficit below the defined benefit. You don't want to be stuck holding the bag at the end if the group or plan dissolves.

I personally would consider setting a modest 3-4% return with a 60/40 portfolio. Make sure manager is not unrealistic with expected returns net of fees. You will be the one responsible for catch up payments, not him.
ace1400
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Re: Cash Balance vs. Taxable

Post by ace1400 »

There is little question that you should participate. While that seems like a high expense ratio, remember, that is TAX FREE (for now) and (assuming she is actually an employee as you stated) is virtually guaranteed against loss - the investment risk is taken by the owners, not the employees. With State/Federal/Obamacare tax, you would be close to 50% tax on interest income on taxable bonds. Depending on the size of the group and age of contributors, you may be the 0.5% expense ratio (>$750,000) very quickly (for partners near retirement, max contributions can be almost $250,000/year each).

This account is also nearly completely protected from creditors via ERISA.

If you invested in a taxable account:
- your account would start out with only 55% as much money
- your interest income would be cut in half every year by taxes
- any money would be easy for creditors to tap
- would be subject to market losses
If someone can point to a taxable fixed income investment that will do better, please let us know.

I would use this account instead of a bond fund for your portfolio. It wouldn't need to change your overall asset allocation.

Ace
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alec
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Re: Cash Balance vs. Taxable

Post by alec »

uvadk wrote:
alec - I do have a copy of the plan summary and have read through it. Do not see any mention of the PBGC. would this be a deal breaker for you?
Probably. Here's a link to a FAQ that contains a link from which you can search for your plan.

http://m.pbgc.gov/pages.html?jsp=wr&lp= ... nsion.html

If you don't see it, you can ask the plan administrator if for a copy of the form that accompanies the yearly PBGC premiums.
"It is difficult to get a man to understand something, when his salary depends upon his not understanding it!" - Upton Sinclair
Topic Author
uvadk
Posts: 57
Joined: Wed Oct 26, 2011 8:55 pm

Re: Cash Balance vs. Taxable

Post by uvadk »

All, great advice.

I asked the advisor and the plan is not covered under PBGC. Apparently plans with fewer than 25 participants are exempt?

However, I feel very good about the medical practice she is in as well as the young partners who are heading up the plan. Really do not worry too much about solvency, etc.

Sounds like the consensus is to max this plan out and consider it part of our bond allocation? All this despite the relatively high fees associated?

DK
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