The threat of the Bush tax cuts expiring in 2010 prompted many high-net-worth individuals to review their qualified plans to ensure maximum income deferral capabilities. I was asked to review a successful plastic surgery practice with five partners. The recommendations I made for them could be applicable to high-income business owners of any type that have only a few employees and need to make up for lost time in planning for retirement.

My client has a mature practice with consistent cash flow and limited administrative costs. His goal was to maximize contributions with pre-tax money to a retirement plan. The plan he had in place was a basic 401(k)/profit sharing plan. Each partner (in their mid-to-late 40s) earned in excess of $250,000.

This client was interested in increasing pre-tax contributions to a qualified plan in order to defer current tax liability. My suggestion for this group of high-net-worth, high-income, small business owners, was to combine a defined benefit/cash balance plan with a Roth 401(k). By combining these two qualified plan options, we were able to dramatically increase their pre-tax contribution limits and offer a Roth 401(k) feature, which is not available outside a 401(k) format to high-income participants.

A traditional Roth IRA has a maximum income limit of $120,000 for single and $179,000 for joint, so most high-income earners aren't able to contribute to a traditional Roth IRA. But, there is no limit with a Roth 401(k) plan. These plans, when combined, offer higher pre-tax contributions, along with a Roth feature. High-net-worth individuals may look to these types of plans to make up for years of underfunding their plans, or for losses incurred during the financial crisis. In addition, this option also offers a level of asset protection from bankruptcy and litigation.

The Defined Benefit Plan

A defined benefit plan/cash balance plan is a qualified retirement plan in which annual contributions are made to fund a chosen level of retirement income at a predetermined retirement date, and contributions are made according to an actuarial formula.

In 2010, the annual benefit payable at retirement could be as high as $195,000 per year. The annual contribution into a defined benefit plan can be even larger in order to meet a retirement income target. A number of factors are involved with this calculation, including a participant's age, planned retirement age, income and investment performance. Also, this type of plan allows clients to maximize pre-tax contributions and provide a form of asset protection. Clients should understand, however, that defined benefit plans are expected to be managed in a conservative to moderate fashion. The actual performance of the portfolio can affect the required annual contribution amount, so having a portfolio that minimizes volatility is prudent.

The Ideal Candidate

So who is the ideal candidate for this combination of plans?

  • Individuals age 45 or older. Contribution allowances are based on actuarial figures, and the older one gets, the more they are allowed to contribute to the plan. Generally, the tipping point that makes the plan truly beneficial starts from age 45.
  • Individuals who want to maximize pre-tax savings above the 401(k) or SEP limit. There is no maximum income limit with a Roth 401(k) plan.
  • Professionals behind on their accumulated savings for retirement. Professionals who are accustomed to making contributions limited to a certain amount can now double or even triple that amount.
  • Individuals with stable and predictable income. The plans require commitments of a certain level of contribution, so only mature businesses with stable cash flows should participate. It's important that individuals understand this before setting up such a plan.
  • This type of plan involves a commitment to invest significant amounts each year for the life of the plan. Funding amounts are fairly rigid once the plan is established, so only individuals who can commit to the contributions for the long term, who truly understand the process, and whose accountants determine it's the right step for them, should consider this move. But for those who qualify and whose situation is conducive to the benefits, the rewards are substantial.

Cameron Short is a senior vice president of investments
with Stifel, Nicolaus & Co. He and his team focus
on the wealth management issues and
practice management of high-net-worth physicians across the country.

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