Kitces' article on Small Business 401k and CBP being overrated.

[jeanpierremelville]

Dear WCI forum:

I was reading an article on Michael Kitces' blog titled "How Small Business Owners May Overvalue a 401k Plan Tax Deferral".

https://www.kitces.com/blog/overstated- ... ring-plan/


Briefly, his thesis is that a business owner may be better off saving into a taxable account instead of funding a small business 401k account. He argues that the required contributions for the employees' account are "permanent costs" whereas the owner's tax deductions (while significant) are temporary and a portion must be paid upon withdrawal.

I don't think there are any illusions about the tax deferred nature of a 401k and how these accounts will be taxed on withdrawal. However, he did offer some examples where the business owner came out ahead if he/she skipped the 401K and just made contributions into a taxable account.

Have others with small practices run the numbers to see for themselves?

I am in a situation where I plan to go into private practice next year and quit my employed position (detailed in a previous thread).
One of the criteria in evaluating the feasibility of my plan is the fact that I may be able to take home more pay even if I make less than my current salary by using a 401K with a cash balance plan (CBP).

For example, if my S corp makes 700K profit and I take 350K as W2 income and 350k into distributions, I can create the following scenario with a safe harbor 401k and CBP.

61.5K into 401k portion as employer contribution (350K x 0.2 = 70K but limit is 61.5K)
120K into the CBP (from calculations I've seen on-line)

Now there are contributions to the employees to be considered but my employees will mostly be in their 20s. I expect to have a total of 4-5 employees and 3-4 will make 50-60K/y and one will make 80K/y. I am 45 and plan to work another 20+ years if possible.

If my spouse works as an office manager, we could put another 100k into tax deferred account (100k W2 income, 20K as employee s401k, 20K as employER contribution, 60K into CBP).

Is my approach a reasonable one in assessing the value of a small business 401K with a CBP?

Has anyone here done a CBP with 401k and been surprised with the costs (both administrative and contribution wise)?

A few points to consider before responding:

- For the CBP, I understand that the contributions are essentially fixed (with some allowances for bad markets, etc.) and it must be funded long-term or at the very least for several years. Those aren't issues for me.
- I've already interviewed a few different firms that specialize in doing CBP such as (Fisher, Ascensus, Emparion) and while they have been somewhat helpful, the initial contact I get is a salesperson so I don't think I can go by just that person's advice.
- I estimated that the CBP will cost about 5K to setup and about another 5K/yr for admin. But again, with the numbers I've given above, the benefits seem to outweigh the cost.
- I posted this on bogleheads as well and got exactly one response.

Thank you.

JPM

[spiritrider]

I don't listen to any alarmism from Michael Kitces (AKA Mr. Chicken Little). He was largely responsible for the fear, uncertainty and doubt (FUD) that Backdoor Roths were a step transaction and you needed to wait a year before doing the Roth conversion.

When the IRS spokesman contemporaneously told Financial Planning Magazine and the Wall Street Journal; "there is no caveat about waiting before doing the Roth conversion." His Royal Highness replied that he knew better than the IRS and there was no tax court ruling to that effect. Of course not, because other than his claimed third party anecdotal report of an IRS agent challenging a Backdoor Roth. There were never any reports of the IRS enforcing the step transaction doctrine with respect to the Backdoor Roth.

As already pointed out, his math assumes that marginal tax rates at deferral and distribution will be the same. While nothing is ensured with the current tax and spend, spend, and spend mentality. It is still reasonable that most white coats will have lower marginal tax rate distribution's. He also totally discounts tax deferral effects on the marginal tax rate, various tax related cliffs and phaseouts , E.g. QBI deduction, etc...

Sure, he acknowledges that tax drag of taxable investments, but he totally discounts the real value of tax-advantaged accounts. The ability to fully transact in the accounts without any tax liability is huge. There is tremendous flexibility and tax advantage to move into and out of investments (rebalancing, asset allocation changes, investment choices, etc...)

Do your own modelling and make your own decision, but personally I believe depending on the employee census a SIMPLE IRA with a 3% employer match, a safe harbor 401k plan with 4% employer match or a New Comparability Method profit sharing plan may make sense. I don't think anyone would recommend his first example, using a safe harbor plan with a profit sharing contribution to maximize the owners annual addition limit. That would entail significant employer contribution cost. Another Red Herring, one of Michel Kites common usage of many logical fallacies in his arguments.

Now, the CBP could be a different story. @foxcpacfp and others have raised the specter of the RMD tax bomb. This can be a real issue for those with too large a tax-deferred portfolio, This can even occur for those (especially couples) with multiple (401a, 401k, 403b, 457b) plans and tax-deferral capability. This can at least partially mitigated with Roth conversions if they don't go away for high income individuals in the future.

Here again, jfoxcpacfp has advocated a mix of tax deferred, Roth and taxable investments. Personally, I advocate a minimum of 20% of total contributions be Roth. This can be Roth 401k, 403b, 457b and BDR/MBDR if the latter don't go away.

[The White Coat Investor]

I find it bizarre that so many business owners see putting money into their employees' retirement accounts as a bad thing. I see it as a good thing. Why wouldn't you want to help your employees save for retirement? Why wouldn't you work to convince them of that plan and your contributions toward it?

An employee should view a nice 401(k) and especially employer contributions into it as extremely valuable. Maybe not quite as valuable as additional salary, but many times, it's even more valuable than additional salary.

We view the "penalty money" we have to put toward our employee's 401(k)s when we max ours out as a feature, not a bug.

[spiritrider]

Hear, Hear!

This is why I am such a fan of New Comparability Method 401k profit sharing plans.

[litovskyassetmanagement]

I've read this article, and his math is suspect. The numbers I get are very different from his. One thing he does not take into account is the cost of paying the taxes to keep a certain amount invested. If you compare taxable with tax-deferred side by side, he omits the opportunity cost of using taxable money to pay the taxes, assuming instead that you start with the same amount, but not adding the opportunity cost to the tax-deferred side. In effect, there is a cost difference to keep the same amount invested in a taxable and a tax-deferred accounts, and this cost difference has to be added to the tax-deferred side (since it costs more to keep the same money in a taxable account). With this taken into account, the math is very different from what he presents. That alone would make a big difference in terms of cost vs. benefit results.

Also, he gives middle of the road examples. If you look at those in highest tax brackets, they get a lot higher benefit than those in lower brackets, and this also has to be taken into consideration. Lastly, tax bracket differential can be quite high for those in the highest brackets right now, so in retirement they get a bigger benefit than those in lower tax brackets. So all of this has an effect on determining the benefit of retirement plans.

One thing is for sure though. If you are in lower brackets, my rule of thumb is that you need to make at least $400k to benefit from a 401k + Profit sharing plan, esp. if you are younger. This is because you can potentially still get some QBI deduction and can keep your W2 low to maximize QBI. Anything over $400k and you are phased out completely from QBI, so your reasonable W2 has to go up anyway, and you might as well set it to what it has to be to max out a 401k plan, provided employer contribution cost is reasonable.

With Cash Balance plans, you also have to look at cost vs. benefit so not everyone should be setting one up. I find that many people are right on the border, and in that case I err on the side of not doing a CB plan vs. doing one. You also need a fairly high net income to afford a CB plan, esp. if you are older. My rule of thumb is at least $500k, but better $600k or so. And employer contribution cost has to be certainly considered here as well.

Usually admin/advisory costs are relatively low/fixed vs. cost of staff contributions, but all of this can be analyzed/modeled prior to setting up a plan, and if your % to owner is reasonable, then you will definitely beat a taxable account. With a CB plan the analysis is done very similarly, and the math says that over a 10 year period it would take a very high return in a taxable account to beat a CB plan with even a small fixed return.

So I would say that retirement plans are not for everyone. Some might be better with taxable when the cost of a retirement plan is not reasonable. This sometimes happens when even a SIMPLE IRA is too costly in terms of employer contributions. For some practices a retirement plan is a benefit as well as a cost, so looking at cost is not everything. But for smaller practices with a single owner or several owners you definitely want to do the math and do a cost vs. benefit comparison. One thing Kitces also forgets is that even if you are breaking even vs. a taxable account, you are better off giving this money to the staff vs. to the government, so the entire situation has to be considered before making a decision to set up a specific retirement plan.

[litovskyassetmanagement]

Dear WCI forum:

I was reading an article on Michael Kitces' blog titled "How Small Business Owners May Overvalue a 401k Plan Tax Deferral".

https://www.kitces.com/blog/overstated- ... ring-plan/


Briefly, his thesis is that a business owner may be better off saving into a taxable account instead of funding a small business 401k account. He argues that the required contributions for the employees' account are "permanent costs" whereas the owner's tax deductions (while significant) are temporary and a portion must be paid upon withdrawal.

I don't think there are any illusions about the tax deferred nature of a 401k and how these accounts will be taxed on withdrawal. However, he did offer some examples where the business owner came out ahead if he/she skipped the 401K and just made contributions into a taxable account.

Have others with small practices run the numbers to see for themselves?

I am in a situation where I plan to go into private practice next year and quit my employed position (detailed in a previous thread).
One of the criteria in evaluating the feasibility of my plan is the fact that I may be able to take home more pay even if I make less than my current salary by using a 401K with a cash balance plan (CBP).

For example, if my S corp makes 700K profit and I take 350K as W2 income and 350k into distributions, I can create the following scenario with a safe harbor 401k and CBP.

61.5K into 401k portion as employer contribution (350K x 0.2 = 70K but limit is 61.5K)
120K into the CBP (from calculations I've seen on-line)

Now there are contributions to the employees to be considered but my employees will mostly be in their 20s. I expect to have a total of 4-5 employees and 3-4 will make 50-60K/y and one will make 80K/y. I am 45 and plan to work another 20+ years if possible.

If my spouse works as an office manager, we could put another 100k into tax deferred account (100k W2 income, 20K as employee s401k, 20K as employER contribution, 60K into CBP).

Is my approach a reasonable one in assessing the value of a small business 401K with a CBP?

Has anyone here done a CBP with 401k and been surprised with the costs (both administrative and contribution wise)?

A few points to consider before responding:

- For the CBP, I understand that the contributions are essentially fixed (with some allowances for bad markets, etc.) and it must be funded long-term or at the very least for several years. Those aren't issues for me.
- I've already interviewed a few different firms that specialize in doing CBP such as (Fisher, Ascensus, Emparion) and while they have been somewhat helpful, the initial contact I get is a salesperson so I don't think I can go by just that person's advice.
- I estimated that the CBP will cost about 5K to setup and about another 5K/yr for admin. But again, with the numbers I've given above, the benefits seem to outweigh the cost.
- I posted this on bogleheads as well and got exactly one response.

Thank you.

JPM

These numbers seem reasonable, but you are correct, very few know how to properly analyze cost vs. benefit properly. For your situation it looks like it would be reasonable, but the first step is to get a good illustration and then get a complete quote for services, and only then you can decide whether the cost will be worth the benefit.

[Hatton]

I find it bizarre that so many business owners see putting money into their employees' retirement accounts as a bad thing. I see it as a good thing. Why wouldn't you want to help your employees save for retirement? Why wouldn't you work to convince them of that plan and your contributions toward it?

An employee should view a nice 401(k) and especially employer contributions into it as extremely valuable. Maybe not quite as valuable as additional salary, but many times, it's even more valuable than additional salary.

We view the "penalty money" we have to put toward our employee's 401(k)s when we max ours out as a feature, not a bug.

Agreed it is easier to have quality employees for the long term if you actually do the right thing.

[jeanpierremelville]

Thank you for the responses everyone.

WCI, I agree with you that the employers should want to do good by their employees in all aspects of work including compensation. However, I can guarantee you that the
vast majority of employees (especially the young ones) do not see retirement contributions as a big benefit since they can't utilize it right away like take-home pay. It's very much like how I see a thread here about legislation possibly ending the Mega Backdoor Roth but 99% of Americans don't even know what that is. A small portion of the population cares very much about saving/ long-term planning. The vast majority don't.

[litovskyassetmanagement]

Thank you for the responses everyone.

WCI, I agree with you that the employers should want to do good by their employees in all aspects of work including compensation. However, I can guarantee you that the
vast majority of employees (especially the young ones) do not see retirement contributions as a big benefit since they can't utilize it right away like take-home pay. It's very much like how I see a thread here about legislation possibly ending the Mega Backdoor Roth but 99% of Americans don't even know what that is. A small portion of the population cares very much about saving/ long-term planning. The vast majority don't.

The main idea behind a retirement plan for a medical office is to provide benefits to the owners. The staff comes along for the ride. As long as the numbers are in your favor, the plan is set up for you, and that's how it goes. You can help your staff by providing them with a benefit and by setting up the plan appropriately to make it easy for them to invest whatever you give them, and whether they appreciate it or not is not really important. I find that most lower paid employees of medical practices don't appreciate a retirement plan. However, potential partners and/or associates as well as higher paid nurses/PAs might be a lot more interested. Also, over time some staff might be more interested as they start accumulating money in their accounts. Also, a retirement plan is typically an extra benefit on top of their W2, so I don't think anyone is going to complain about that. Everything starts with a well set up and managed plan and as long as everyone is happy, that's all there is to it.