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  • litovskyassetmanagement
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    Past performance does not dictate future returns.  But the graphs in this link highlight the value of holding stock longterm.

    http://allfinancialmatters.com/2012/08/29/sp-rolling-total-returns-1-5-10-20-25-and-30-years/

     

    the S&P 500 has never suffered a loss in a 20-year period.  Only a few 10 year periods have had a negative return.

     

     
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    Please see the chart above I posted titled 'The Stock Returns Never Average' above.  It matters very little what rolling returns are (and these are nothing but averages over longer and longer time periods).  Why?  The markets are fat-tailed, and fat-tailed statistics has different properties from Gaussian statistics.  One of the properties is that past averages have no bearing on the future (in a Gaussian world past averages are stable and future returns will converge to them eventually). So just because S&P only had a 50% loss doesn't mean it can't go down 60%.  And just because the longest recession was 10 years doesn't mean it can't be 15. And 'never suffered a loss' is not particularly useful if you are losing 50% of your portfolio (and this would have a huge impact on your total and annualized return).  Timing matters when investing in risky assets, so when you just accumulated say $5M and the market goes down 50% this will significantly impact the total return/annualized return, and even though over 20 years you might suffer no loss (by the way it could be 25 years, and 30 years as longer/deeper recessions come about, which is only a matter of time), the net result would be catastrophic for those holding 100% stock portfolios hoping they'll recover (and getting hit by another longer recession with a deeper bottom). Fat tailed markets simply have more degrees of freedom than Gaussian ones, and so things that Gaussian statistics says is impossible is very much possible (and not only that, but also bound to happen eventually).  So to me the only thing that matters is limiting the downside, and getting whatever return that one can get with a barbell allocation.  Historically this has worked well (except during the times when interest rates were low, due to artificial government involvement).

    Vanguard's own retirement distribution calculator shows that a 50:50 allocation is more stable over longer periods of time (30-40 years) than 100% stock allocation (when no more contributions are made).  Also as you get older, subsequent contributions have less and less impact on the overall portfolio, so Vanguard's analysis applies much earlier than distribution.  Bottom line is that once we take into account real risk that the market statistics shows us, in order to manage long term risk to a large portfolio, the traditional age-based asset allocation is significantly flawed, and most people's understanding of how long term risk works is also flawed, which can be easily demonstrated with basic mathematics (even Gaussian math works for that). Risk increases with time, and no amount of averaging will be able to hide it, so in light of that, I believe that only a risk-based approach is the most prudent long term strategy vs. target date or age-based approach.

     

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  • litovskyassetmanagement
    replied




    You have no idea if you error will be small by using a conservative approach/lower return assumptions.  Very easily your bonds approach will also greatly underperform.  Ten years is just a number you made up for length of plan.  These plans are supposed to be indefinite.  You have no idea what will actually be more damaging.  Good luck matching the S&P with the bond approach.
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    I never said I'm using all bonds.  On the contrary, if you re-read what I posted above, I'm very much in favor of holding stocks.  My approach/allocation is different from what is typically done, that's all. Nobody knows whether this will do better or worse than any other approach, and when I keep talking about lower return, that's not guaranteed either - it could be a higher return.  Over the past 40 years the return of this type of allocation matched that of S&P with no bonds, but I'm just being extremely careful not to try to make predictions from past returns.  The whole point is managing risk, and if this can be done with less volatility, then that's what I'm shooting for.

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  • grp2c
    replied
    Past performance does not dictate future returns.  But the graphs in this link highlight the value of holding stock longterm.

    http://allfinancialmatters.com/2012/08/29/sp-rolling-total-returns-1-5-10-20-25-and-30-years/

     

    the S&P 500 has never suffered a loss in a 20-year period.  Only a few 10 year periods have had a negative return.

     

     

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  • litovskyassetmanagement
    replied




    I think both Rex and Kon make insightful points.  I think the type of allocation, agressive or conservative, depends on the client.

    For the scenario of a client who has multiple employees, is close to retirement, or has already amassed a large 401k plan, a conservative allocation is probably best.  As far as I’m aware, this has historically defined the client seeking out a DB/cash balance plan.  With multiple employees, a conservative allocation will reduce employer liability.  If the client is close to retirement then the volatility of an agressive allocation may cause issues with cash flow and changing contribution amounts.  If the client already has a large 401k plan (this client probably already has the other two qualities) then a large % of bonds in the DB may still represent a small % in his total portfolio.

    However, I think Rex represents a different client which is similar to me.  Late 30s-40s, at least 20 years from retirement, no employees, smaller 401k plan, uses broad based diversified index funds.  I agree that a DB/cash balance plan is not about contributing the most over time to maximize tax deferrals but rather paying the least to get the same defined benefit.  So if a client is 15-20 years away from retirement, no employees, okay with volatility in his portfolio, and capable of handling changing contribution requirements due to volatility with regard to cash flow then I think an agressive portfolio is fine.   If a client has 15-20 years to fund the plan, then I don’t think volatility will significantly affect contribution requirements (however I need to confirm this an actuary).  One just needs to make sure plan does not become overfunded if investments do well.

    I was told by a TPA to aim for an annual investment return of similar to the plan, 5.5%, however I struggle with the opportunity cost of not being agressive.

    Interestingly, as long as it does not affect cash flow, I think the volatility with an agressive allocation is actually good in the long term with a DB plan.  If stocks are down, the plan becomes underfunded and contribution requirements are raised.  If stocks are up, the plan becomes overfunded and contribution requirements are lowered.  Basically, it forces buy low, sell(or not buying) high

    I will likely plan to follow a target date retirement glidepath with maybe 10% more bonds for my DB/cash balance plan.

    Thoughts?

     

     
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    In a solo plan you can definitely use any approach that fits your goals.  I would start with an overall allocation and figure out where the DB plan fits in.  As I said before, 10 years is not a long horizon at all so it is inconsequential what the DB allocation is as long as your overall allocation is where you want it to be.  Higher return is always more preferable to a tax deduction. Volatility is simply not good for a large portfolio in the grand scheme of things because of the timing issues, so a higher return (in theory) can become a lower return due to volatility (in practice) because of bad timing (which we have no control over).  Therefore, my position is that lower volatility is always preferable, regardless of where the money is (401k or DB), and higher return is not guaranteed by having a higher volatility portfolio.  That said, I prefer a barbell-type approach where I take significantly more risks on one side of the portfolio than S&P500, and significantly lower risks on the other side.  This is an 'all weather' type allocation that's also known as barbell (and in practice this results in a lower volatility).  Though historically these allocations generated returns on par with S&P with significantly lower volatility, we don't know if this would be the case going forward, but this 'target risk' approach in my opinion is a better approach than target date one.  So basically, my approach is to dial down on the risk by using Treasuries, and take all of the risk on the stock side.  Thus it does not matter where the investment occurs, as long as the overall allocation fits a specific goal, then individual components can be managed accordingly.

    Those using target date approach will have a significantly more difficult time managing their allocation, and timing issues come into play a lot more with this approach, that's why I prefer the target risk one any time of day, regardless of what returns are.  I'm more worried about losses than not getting a higher return (which we have no control over anyhow), so I'd rather get a smaller error on a lower return assumption with a barbell-type allocation than a huge error on a higher return assumption with a high volatility portfolio.  For those accumulating millions risk is a lot more damaging than not getting extra return (which is far from guaranteed in any case).

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  • grp2c
    replied
    I think both Rex and Kon make insightful points.  I think the type of allocation, agressive or conservative, depends on the client.

    For the scenario of a client who has multiple employees, is close to retirement, or has already amassed a large 401k plan, a conservative allocation is probably best.  As far as I'm aware, this has historically defined the client seeking out a DB/cash balance plan.  With multiple employees, a conservative allocation will reduce employer liability.  If the client is close to retirement then the volatility of an agressive allocation may cause issues with cash flow and changing contribution amounts.  If the client already has a large 401k plan (this client probably already has the other two qualities) then a large % of bonds in the DB may still represent a small % in his total portfolio.

    However, I think Rex represents a different client which is similar to me.  Late 30s-40s, at least 20 years from retirement, no employees, smaller 401k plan, uses broad based diversified index funds.  I agree that a DB/cash balance plan is not about contributing the most over time to maximize tax deferrals but rather paying the least to get the same defined benefit.  So if a client is 15-20 years away from retirement, no employees, okay with volatility in his portfolio, and capable of handling changing contribution requirements due to volatility with regard to cash flow then I think an agressive portfolio is fine.   If a client has 15-20 years to fund the plan, then I don't think volatility will significantly affect contribution requirements (however I need to confirm this an actuary).  One just needs to make sure plan does not become overfunded if investments do well.

    I was told by a TPA to aim for an annual investment return of similar to the plan, 5.5%, however I struggle with the opportunity cost of not being agressive.

    Interestingly, as long as it does not affect cash flow, I think the volatility with an agressive allocation is actually good in the long term with a DB plan.  If stocks are down, the plan becomes underfunded and contribution requirements are raised.  If stocks are up, the plan becomes overfunded and contribution requirements are lowered.  Basically, it forces buy low, sell(or not buying) high

    I will likely plan to follow a target date retirement glidepath with maybe 10% more bonds for my DB/cash balance plan.

    Thoughts?

     

     

    Leave a comment:


  • litovskyassetmanagement
    replied
    I'm glad you've figured it out and it worked out for you.  The problem with getting higher return is that there are no guarantees, and just adding more to stocks isn't going to necessarily produce a higher return over 10 years.  You might or might not end up better, but the question is, better than what?  We are talking about a total return picture here, not just the Cash Balance plan, so I'm rather confident that my approach will work just fine for anyone without having to guess.  "Better" is in hindsight - many ended up better in 2000, but in 2002, many of the same people ended up a lot worse.  Risk management is, in my mind, more important than getting a higher return over a certain time period.  It is not a race, but a marathon, and those who end up in the 'safe zone' are the ones who won, regardless of what % return they had, but only if they avoid taking heavy losses in the process.

    The best strategy is to max out the CB plan and move the money into the 401k plan after that, but getting a higher return really depends on multiple factors, and even though all of us invest in broad market indices, there is no guarantee that over 10, 20, or 100 years that you'll get a higher rate of return with a stock-heavy allocation.  There is really no way to tell, and that's all I was trying to convey.  I know this is contrary to what many people believe, but I prefer to stick to a more balanced approach and to shoot for a reasonable return rather than go all out for an aggressive one and end up on the wrong side of the return equation.

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  • litovskyassetmanagement
    replied
    You are getting at a very fundamental question that is beyond the scope of Cash Balance plans, and has to do with asset allocation and how one is selected and managed with time. I have a different taken on this, because stock market statistics suggests that commonly provided answers are definitely wrong.

    The issue is that you seem to think that having high exposure to stocks guarantees a higher return over 10 years vs. an allocation that has more bonds.  That's the type of assumptions I try to avoid because they can lead to bad outcomes.  There is no discussion about increasing risk later.  The allocation will depend on an individuals' specific situation, not because some rule of thumb says that your stock allocation has to be X when you are age Y.

    As evidence, I offer the chart below (there is a lot more than that, but this chart illustrates the main point very well).  Nobody on Earth has any idea what their return is going to be, and the longer the horizon, the less uncertain the actual return will be.  So it is pointless to make assumptions about return.  That said, it is very dangerous to overestimate your potential return.

    So in fact, if I make a mistake with my assumptions (erring on the side of lower returns) and get an even lower return or a higher return (so if I assume 5% but get 4% or 6%) that's a lot more preferable to assuming 8% but getting 6% or even lower).  The upside does NOT matter when you have significant downside, and the only way to limit it is by using bonds.  This is just basic risk management for those who accumulate large portfolios.  You do NOT need to get an 8% return to retire will millions, on the contrary, those who try to hit high return can eventually end up with a lower one, and no amount of holding high risk assets will get you to your target return, so this is basically a form of gambling.

    My philosophy has to do with risk management and how to make sure that you don't end up on the wrong end of the return scale.  The only known way to do that is to limit your exposure to risky assets via a barbell approach where you have significant exposure to high risk assets tempered with a larger than usual exposure to safe assets.  Mathematically, this is an optimal approach given the markets are fat tailed.  How exactly this is to be implemented is anybody's guess, but this is a much more prudent approach than simply loading up on stocks and hoping that they'll deliver, which can hurt those who accumulate significant money over time.

     

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  • litovskyassetmanagement
    replied




    Feel free to display your math advantage.

     

    Its not about you.  But even in your situation, you likely make assumptions that favor the DB plan.  For instance you constantly promote the idea that it needs to be invested conservatively within the DB plan (which is false but might be a decent idea for spooky bc of the number of employees).  So if Spooky took the money and invested it otherwise DC plan or taxable account then it likely wouldnt be invested so conservatively especially since spooky is someone who posts here.  Also this would then more easily allow for Roth conversions later from the already in place DC plan.  I doubt you figure these into the presentation especially since you constantly post here that a DB plan has to be conservatively managed.  It can be and for some people its even a good idea but its not a requirement.
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    Good math skills when put to use for the best interest of the clients are a great asset vs. many others who are trying to fudge numbers to sell a product that is inappropriate. The key is to model all possible likely scenarios, not cherry pick the best one, and because of my mathematical background, I can't possibly be satisfied with a half-baked answer just to get someone in the door - this goes against my principles.

    Because a DB plan would be around for no more than 10 years for most solo owners, it is a mere blip on the radar for most docs in terms of asset allocation.  I primarily work with group practices or practices with employees, so in that case the risks are much greater, requiring a more conservative approach, but in all cases I can't justify aggressive allocation in a DB plan, especially if you can adjust your 401k plan allocation (which is especially true for solo docs, and docs who have had a 401k plan for a while so they built up significant 401k plan assets). So in fact, in most cases the return from adding a DB plan won't be significantly lower (though I often allow for several % lower return, but only over a decade, which again won't make a huge difference in the grand scheme of things). I prefer to err on the lower return side on both the Cash Balance and the 401k, but for those in high brackets having a Cash Balance plan (whether now or later) can work out very well.  I see many younger docs who want to retire in their early 50s and they are the ones telling me about their income instability going forward - I would agree that waiting until you are older makes more sense, especially when plan demographics are not ideal.

     

     

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  • litovskyassetmanagement
    replied




    His average tax isnt necessarily going to be lower.  If he has a lot of other taxable income then it could still be taxed at the same rate.

    If you do get a “professional” opinion, keep in mind these folks are very interested in making the sale.  I have yet to come across one that doesnt weigh some of the unknown factors towards assumptions that make purchasing such a plan seem beneficial.  For instance the idea that you dont know what your income will be in the future is pretty much a scare tactic.  So far in medicine, this hasnt been a widespread problem.

    I have one by the way but im the only employee.  I did it at age 39 and if i had to do it all over again then id wait until until late 40s.
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    That's why it is not a good idea to make assumptions about future taxable income without knowing exact details.  And yes, if you are in the same bracket in the future, your average tax rate will be lower by as much as 11% (you can do the math yourself for the 39.6% bracket).

    I do agree that almost everyone who's not a fiduciary (such as TPAs, actuaries, brokers, 'advisers') are in it to sell plans, and that's unfortunate.

    That's why as a fiduciary I do not sell plans, I provide unbiased advice.  I turn away many more docs than I end up working with because I do not like the idea of having a plan that makes no sense.  Doing side by side analysis (CB vs. 401k plus after-tax, for example) is an easy way to see which approach is better in a specific situation, and when the costs don't justify the benefits, the answer is no.

    Also, my analysis is always straightforward with minimal assumptions.  I prefer to weigh only the known factors, but the key here is to manage future risk so that such factors as sudden loss of income do not create problems.  This is why for a CB plan it is key to have a stable income so that one does not have to close this type of plan prematurely.  Better not have it in that case.

    Loss of income and/or merging with a larger practice is happening all the time, so that would lead to a termination of a Cash Balance plan.  That's another reason why the decision to open a CB plan has to be made very carefully with multiple layers of considerations, from cost to risk and everything in between.

     

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  • litovskyassetmanagement
    replied




    Thank you for your replies. I guess my concern is that at 20% going to other employees plus paying marginal tax rate upon distribution (in a cash balance plan) is very similar to paying marginal tax rate now and paying 20% capital gains tax upon distribution (in a taxable account). (I’m not convinced I will be in a lower tax bracket in retirement). I realize that in the former scenario, investment would be growing tax deferred, that there are benefits to tax diversification (our taxable accounts are growing out of proportion to our tax deferred accounts), that I’d rather the money go to my employees rather than the tax man, etc.; however, there seem to be some risks to these things as well.
    Also is there must be a maximum total amount that a plan like this can have? I seen in this forum some mentioning about running the plan for just ten years. I recall there was some thoughts in Washington DC to place caps on total retirement contributions, but I didn’t think there were laws to that effect. The owners are relatively young (early 40s). Would one benefit more from waiting to start a CBP until they could place more money to the owners as we age (due to the age discriminatory nature of cash balance plan formulas), or start as early as possible? Again, thank you for your time and consideration.
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    No, it is not 20%, it is much lower than that.  It really depends on demographics and plan design, and with a good design it might be possible to minimize employer contribution.

    Even if you are in the same tax bracket in retirement, your average tax rate would be significantly lower (if this makes sense).  Your contributions are made from your highest tax bracket, so there is tax differential just due to this difference.

    I wouldn't worry about what DC is planning to do, not much is getting done anyway.  Yes, this plan runs for about 10 years if you are going to max it out.  It really depends on many factors whether you want to start this plan now or later.  Many docs start CB plans even when they are young because there is no guarantee that income will be forthcoming in the future, and also because they want to retire earlier, the decision on when to start a CB plan is an individual one, and depends on many factors (such as your retirement age, amount you want to contribute, how long you want to run this plan for, your marginal tax brackets, employer contribution, etc).

    What I typically do is a side by side analysis of various scenarios so that a solid decision can be made in a specific situation.  Rules of thumb are not very useful, but actual numbers can help you understand what your options are and which one might be a better choice for you, and whether you should start a CB plan now or wait until later.  All of this is different for different docs, so individualized analysis is required to make the right decision.

     

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  • SpookyLadySideshow
    replied
    Thank you for your replies. I guess my concern is that at 20% going to other employees plus paying marginal tax rate upon distribution (in a cash balance plan) is very similar to paying marginal tax rate now and paying 20% capital gains tax upon distribution (in a taxable account). (I'm not convinced I will be in a lower tax bracket in retirement). I realize that in the former scenario, investment would be growing tax deferred, that there are benefits to tax diversification (our taxable accounts are growing out of proportion to our tax deferred accounts), that I'd rather the money go to my employees rather than the tax man, etc.; however, there seem to be some risks to these things as well.
    Also is there must be a maximum total amount that a plan like this can have? I seen in this forum some mentioning about running the plan for just ten years. I recall there was some thoughts in Washington DC to place caps on total retirement contributions, but I didn't think there were laws to that effect. The owners are relatively young (early 40s). Would one benefit more from waiting to start a CBP until they could place more money to the owners as we age (due to the age discriminatory nature of cash balance plan formulas), or start as early as possible? Again, thank you for your time and consideration.

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  • adventure
    replied


    Living a long life can also help, as longevity is a factor in all of this too
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    : )

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  • litovskyassetmanagement
    replied




    Is there a rule of thumb as to what percentage of a cash balance plan’s allocation should go to the principles to justify starting a cash balance plan? We have a practice of about 25 employees including 3 physicians and are contributing maximum allowable 401k with safe harbor and profit sharing plan and are considering adding a cash balance plan. I understand that if 95% of money goes to the owners, it’s a great idea. But what if 85% goes to the principles? Or only 80%? Obviously 80% beats what is taken home after taxes, but it still a win after you eventually pay taxes? I know that future tax rates are not knowable, and that there is likely some tax arbitrage from lower capital gains rates/income tax rates in retirement compared to one’s peak earning years, but is there an idea of how much money should retained by the owners of company to justify starting a cash balance plan?
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    It depends on your individual tax situation.  Don't forget that your employer contribution is tax deductible, so with an 85% to owner, and a 50% tax bracket, your actual % to owner will be higher, so if my math is right, in this situation your % to owner would be 92% if we take taxes into account, which is not bad at all.

    But ultimately, what has to happen is a design study to optimize employer contribution. This can help you save significant money because not all designs are equal. The next step is to make sure that no AUM fees are paid, and that all providers are getting a fixed/flat fee (to control your overall plan services cost).  Also, whoever your providers are, there should be only one TPA for both plans (so if your existing provider is a bundled platform, you might want to hire a good TPA for both plans and use a low cost record-keeper instead).

    Also, if your current profit sharing % to owner is X, I doubt that adding a CB plan would somehow decrease this significantly.  If anything, you might not increase much from that amount (esp. if the owners are young), but if you are doing profit sharing successfully and are happy with the results, adding a CB plan should only improve the % to owner situation.

    As far as what the lowest % to owner that's acceptable, again, that depends on your personal situation.  I typically run this type of analysis comparing plans side by side including costs, tax brackets, and how long a plan is around, etc.  For those in higher brackets, a lower % to owner is acceptable, and since you will be running a CB plan for only about 10 years (if you contribute the maximum, this is about how long it will be around), you will most likely be better off doing this vs. not doing anything or investing after-tax.

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  • SpookyLadySideshow
    replied
    Is there a rule of thumb as to what percentage of a cash balance plan's allocation should go to the principles to justify starting a cash balance plan? We have a practice of about 25 employees including 3 physicians and are contributing maximum allowable 401k with safe harbor and profit sharing plan and are considering adding a cash balance plan. I understand that if 95% of money goes to the owners, it's a great idea. But what if 85% goes to the principles? Or only 80%? Obviously 80% beats what is taken home after taxes, but it still a win after you eventually pay taxes? I know that future tax rates are not knowable, and that there is likely some tax arbitrage from lower capital gains rates/income tax rates in retirement compared to one's peak earning years, but is there an idea of how much money should retained by the owners of company to justify starting a cash balance plan?

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  • litovskyassetmanagement
    replied




    So you are saying that that amount of after tax deferral can affect p/s and cash balance portion of nondiscriminational testing ?

    Thank you. You see , ? we have another selling point for the 401k vs Simple Ira for doctors who can not do profit sharing plan -ability to do mega-backdoor roth.

    What do you think , what is the value of that 5500$ backdoor roth in a high tax bracket vs taxable account?(no cost Simple IRA vs extra cost for 401k?assuming same 3% match)
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    Yes indeed, that's what the actuary said.  There is no need to do after-tax contributions though unless you are a solo guy with a small 1099 income who wants to stuff money into the Roth bucket.

    1) If you are in a high tax bracket, there is not much advantage with a Safe Harbor 401k vs. a SIMPLE, that's for sure!

    2) You would want a custom-designed 401k with profit sharing, and that would beat SIMPLE hands down.  In that scenario you can do Roth salary deferrals (though you would NOT want to if you are in the highest tax brackets).

    3) Roth is just another bucket since TIRA is non-deductible anyway, so you just do it because you can.

    4) The whole point is that in-plan Roth conversions can be done at various points when the tax bracket dips, though ideally this is done at or near retirement.

    5) I don't see much use for the after-tax contribution given that most practice owners can easily max out the tax-deferred 401k at $53k.

    6) You can indeed have a bigger Roth bucket if you have a Combo plan.  In that case you can have a huge tax-deferred CB contribution, and you might be able to convert some of your 401k balance every year to Roth - this is another alternative I haven't done calculations on, but this is definitely a viable approach depending on the size of your tax-deferred bucket.

    Lots of ways to play this game, but I would definitely try to get as much of the tax-deferred money converted to Roth, and it does not have to happen periodically during the maximum tax bracket years - it can happen in bursts thereafter (at or near retirement) and still be a very viable strategy for those in the highest tax brackets.

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