Out of the Box Retirement Planning

“I wish I could retire sooner” is one of the most frequent comments I hear from colleagues. There are only a few ways most of us can do this. Try to make more money. Try to increase the rate of return of our retirement investments. Try to win the lottery. Save more of our current income to make our retirement account grow faster.

Making more money practicing medicine is getting increasingly hard to do. Since risk and reward are related, increasing returns on investments is by definition a “risky” proposition. There a few with a knack for investing who claim to have it all figured out. Although, I suspect most fall into the category of compulsive gamblers whose winning streaks give them a drug-like high and whose losses are erased from memory. Those who really do excel at investments obviously only continue to work because they choose and needn’t read any further. I don’t think I need to explain why the lottery isn’t a viable retirement option (although, I admit that I still buy a ticket most weeks). Putting more pre-tax income away for retirement is definitely worth exploring.

Most physicians are familiar with defined contribution retirement plans and defer the maximum amount of income for retirement, $51,000 for 2013 (or $56,500 if you are over age 50). A cash balance plan is a type of defined benefit retirement plan that is growing in popularity, especially among professionals, and allows much higher income deferrals.

A cash balance plan can be added to your existing defined contribution plan and can allow you to contribute in excess of $200,000 a year depending on your age. The beauty of deferring income is the amount of tax that you save. For example, if you defer $100,000 and your marginal tax bracket is 40 percent, you pay $40,000 less taxes that year. The whole $100,000 then grows tax-free until your retirement. John Bogle, the founder of Vanguard, calls it, “the mathematical miracle of tax-free compounding.”

Equal Retirement Income Security Act (ERISA) law is complicated and a complete explanation of cash balance plans is beyond the scope of this blog. In simplest terms, a cash balance plan is pre-tax money that is put aside for retirement with a guaranteed, conservative (3 percent-to-5 percent) rate of growth. Unlike defined contribution plans where many participants direct their own investments, the cash balance plan contributions of all participants are pooled in a single account. Each participant has a hypothetical account that reflects his annual contributions and guaranteed interest rate.

At retirement the participant receives the value of his hypothetical account. The account value can, then, be rolled over into an IRA or converted to a lifetime income stream. Unlike the contributions to a defined contribution plan where contributions are voluntary, defined benefit plan contributions are mandatory and an actuarial evaluation is required annually adding a layer of complexity not found in traditional defined contribution plans. This costs money and these plans are more expensive than their defined contribution relatives. For most, however, the benefits far outweigh the additional administration and costs.

Using the “mathematical miracle of tax-free compounding” may be the right answer for you. If you are one of the growing numbers who wish they “could retire sooner,” ask your advisor to explore the possibilities of how a cash balance defined benefit plan might add significant value to your current plan.