Transcript
Intro
Stephan Shipe: Welcome back to the Scholar Wealth Podcast. This week we begin with an anesthesiologist doing locums through an S-corp who already maxes a solo 401(k) and is weighing whether a cash balance plan is worth the added complexity to shelter another $200,000 per year. Next, we hear from a contingency fee attorney with wildly lumpy income who has no intention of ever retiring and is looking for a real system instead of reacting to whatever the last case brought in. Finally, we address a listener building a trust for his adult kids who wants the inheritance to preserve their drive rather than to replace it, and is asking what provisions are worth considering. So let’s go ahead and get started with question one.
Question 1 – Is a Cash Balance Plan Worth the Complexity at $650,000 of Locums Income?
Stephan Shipe: I’m an anesthesiologist doing locums through an S-corp, grossing around $650,000 per year. I have a solo 401(k) that I max out. I’m thinking about a cash balance plan that would let me shelter another $200,000 a year. Every article I read is written by someone selling them, so I’m looking for some independent insights.
Yeah, I’m a huge fan of the cash balance plan. I think it’s a great option. There are some caveats associated with it that we can go through, but you’re in the income where one starts to make sense. And the reason for that is, maxing out the 401(k), you’re already around the seventy thousand dollar mark, depending on how old you are and what kind of catch-up provisions are in there. So you look at six hundred and fifty thousand dollars, let’s knock off fifty percent of that for taxes. So now you’re at 325 — especially because you’re paying self-employment taxes and everything else in there, it might actually be a little bit less. So let’s call it an even 300 that you have left. So 300 is what you have left over for you to spend every single month. You take off 70 off of that, that means you’re likely at 230 or so for you to spend. So we’ll call that 240. So you’re at $20,000 a month.
So if you’re spending anything less than twenty thousand dollars a month, then going through the cash balance plan can make sense. But what I’ve seen is that that’s a tight budget, depending on what you’re looking at, especially when you’re wanting to stack another $200,000 in there. Now, that would be tax-deferred, so you’d get some of that back. But that’s still real money you’re throwing into there, or really trading — $200,000 for another maybe $70,000 or so in tax savings. So you’re still netting out $130,000. When you’re only having $200,000 left over after tax and you’re still funding the 401(k), I think you’re going to get capped out really quick, unless you’re going to have an increased income over time.
And that’s what worries me about it. I’m a fan of the cash balance plan, because who doesn’t love an extra $200,000 or so that you can stack into a tax-deferred account? Depending on how they’re set up, this is actuarial-based. So it is a pension, right? It’s a cash balance pension. So you’re going to have the same types of requirements for a pension. There’s a lot more paperwork. There’s a lot of administrative overhead that drags on any of those tax savings that you get. So it’s not free. It’s not like a solo 401(k) where we’re going to set it up, check a box, and you’re good to go. There’s going to be actual work. There’s going to be reviews of the plan that happen throughout the life of the plan. Most of the time we see the plan open for a few years, and then after three to five years, the plan shuts down. And then you take that money and it gets invested into an IRA as a rollover, which can be a good option.
But if you’re saying, Stephan, this looks good, I like the $70,000, I’m going to put $200,000 a year into this cash balance plan — I’d really look first to make sure that you’re truly going to be able to fund it with $200,000. And if the answer is yes, are you going to be able to do so for the next three to five years? If you’re not able to do that for the next three to five years, it’s probably not worth the added complexity of dealing with it for a year or two. Or worse, getting into issues where your pension fund is now not in compliance for whatever reason, because you don’t have the money to fund it, or you don’t have the time or team to put it together. So just be careful — we don’t want to jump into that too far.
Before you do any of that, I would really consider what your brokerage account looks like. And I know that sounds kind of odd, because the cash balance plan has so many benefits, but what I don’t want to happen for you is for you to stack up in the situation where you have all of this money in tax-deferred assets, and then you need some liquidity and you can’t get to it, because everything’s in a 401(k) or a pension fund. While it does great for you up front from a tax perspective, it really burns you when you need any type of liquidity and flexibility. We want to add some degrees of freedom into your financial life. So if you don’t have a sufficient brokerage account now — making six hundred and fifty thousand dollars a year, let’s say you’re spending two hundred — I’d say you at least need two to five hundred thousand dollars in a brokerage account first, before you go and say, I’m going to start stacking more money away and locking it up for years, since I can’t touch it till I’m 60, or 59 and a half.
So that would be step one. I’d look at where you’re at. Do you need more tax-deferred buckets? Then, are you going to actually fill it in the right way? If you’ve only got another $50, $100,000 to put away on an annual basis, that’s a hard sell for me. I think that’s right there. If you were to ask me a breakeven point, I’d say you need a solid hundred thousand dollars a year in savings to make sure the cash balance plan is something like a slam dunk for you. Under that, I could argue that a brokerage account is probably pretty important, especially if you don’t have one built up for the liquidity aspects. And from a tax perspective, it’s not going to be tax-free — tax-deferred just means it’s going to be taxed. But the odds are you’re not going to be touching a lot of that brokerage account, and it’s going to get a step-up in basis way in the future from an estate perspective. So I’m a fan of them. They can work. I think you’re right on that line of whether or not it makes sense for you, or whether or not you need to shore up some other areas of your finances before you start locking up even more.
Question 2 – Building a System Around Wildly Lumpy Contingency Income When You Never Plan to Retire
Stephan Shipe: I’m a plaintiff’s attorney in my mid-40s, running a small contingency firm. My income is all over the place. Last year we settled a big case and I took home around 2.1 million. The two years before, we were closer to 380,000 and 520,000. I’ve got about 4.5 million invested and maybe a year of expenses sitting in cash, but the rest of my financial life is pretty ad hoc. Case costs come out of the operating account. My spending creeps up in the good years, and I don’t really have a good sense of what a normal year looks like. I also don’t ever plan to retire. I love the work and can’t picture stopping. So I’m not really planning around a finish line, which most planning seems to be built around. Any recommendations for building a system?
Absolutely, plenty of recommendations on this. It’s not uncommon. I deal with a lot of plaintiff’s attorneys, or situations where we have a lot of lumpy income. And you’re right, you kind of get into this situation where your financial life is not very Googleable. It’s hard to figure out what’s going on, because there’s no normal. Normal doesn’t exist in your life. Normal is — volatility is normal in your case, both in cash flow coming in and cash flow going out. Because you go win a big case, like you’re saying, you’re going to bring in $2.1 million in one year. Yeah, spending probably went up, because you made $2.1 million and it’s a little easier to spend. Years where you’re making $380, probably not as much, right? You don’t have the flexibility there. It’s the money in your hot pocket issue. You go into the store, you have a bunch of cash in your pocket, you’re more likely to use it. So that’s not uncommon. I don’t think you’re doing anything wrong in that one. And for me to come out and say, well, just keep your spending even every single year, makes zero sense whatsoever, because that’s just not going to behaviorally be an option that makes a lot of sense.
So then what we need to do is try to extrapolate what is a normal expense. So you would start to go backwards, and you’d say, the year you make 2.1 million, maybe you went and bought a boat. You buy a boat, that’s not going to happen every single year. So you need to cut that out of your expenses. And what you find, and what we typically find, is there tends to be a normal expense that tends to show up for housing, day-to-day expenses, right? Your food, fuel, cars, all of that type of stuff. That stuff stays pretty stagnant over time. The things that really change are the discretionary stuff, the fun stuff, and travel. I bet you if you were to go back over these three years, your expenses really haven’t changed as much as you think. The stuff that changed was, you probably took a great trip when you were making $2.1 million a year, and a trip that didn’t look anything like that when you made $380,000 a year.
So we want to try to pull that back. And then I would look at, which of those years do you like best? Within reason, you’re going to like the boat year, but we’re going to pick a year that’s normal. Like, what would you consider — no, I don’t want the year that things were tough, we weren’t able to do all the things you want. Pick a good year. Maybe that’s five hundred thousand dollars or so. And I want you to go take a couple years and go throw that in cash and T-bills. Super conservative. And you can look at that and say, that’s ridiculous, I have 4.5 million, I’m not going to drop a million and a half into cash and T-bills.
The way I would look at it is, your income is so volatile, and your income coming in is driving everything. So your best ROI has nothing to do with the market. Your highest ROI has everything to do with human capital, your ability to go have another two, three, four million dollar year. So that’s where all your focus should be. And you don’t want to pull from that focus by being worried about the stock market going up or down. We need to set aside a few years to allow you to have some dry powder for spending. So that way, if you’re investing in a case, if it’s taking more time for things to go on, you can do that without having too much of a concern over whether or not you’re going to be able to take the vacation you want to take this year, and you have the money to do so.
Right? You’re in your mid-40s, 4.5 million. Let’s do it. Even if we did some rough math on that, you never touch that four and a half million. It doubles every 10 years on average in the market. So you go from four point five in your mid-forties, you go to nine in your mid-fifties, you go to eighteen in your mid-sixties, and you’re set. Right? I mean, after that you go into your thirties — you go into your seventies, right? 30 million plus into your seventies. And you’re not planning to stop working. So I want you to have the option to stop working. I don’t want you to not plan for it.
So you’re right on this whole finish line scenario, where we look at it and say, all planning is based on today’s — here’s your retirement date. That doesn’t work, right? For most people, that never works that way. Very few people actually retire, at least the people that we’re dealing with, and people who are running incomes like you’re doing that are volatile. You like the game. So you’re not just going to stop at 55 and say, well, my assets are now 9 million, that’s all I need, I’m done. You’re just going to keep going, because you like it. So there’s not a huge need for you to save.
So what’s the one thing that derails all of this? The one thing that derails all of this is you not being able to earn the money you need to earn. And that’s why we’re putting the money aside for a couple of years, right? Stack it up, build it up, and then let that 4.5 million just roll. Let it hit the nine million, let it hit the 18 million. And then you have a big year where you’re making two, three million dollars a year. Spend it all. It doesn’t matter, because you have plenty of money in the bank that’s continuing to compound. The only thing we’d have to worry about, when I’m saying spend it all, is making sure that the money you’re spending is not adding additional expenses to that base spending level. Within reason, that’s going to be expected. But you don’t want to go add a bunch of real estate that now has a bunch of operating costs that are going to make that 380 year impossible for you to fund your lifestyle. We still want to look at a bad year and say, it’s going to be rough, but you’re still going to be able to hit most of your expenses. So I’d focus on liquidity, and I’d focus on making sure none of this is really stacked with debt. You need flexibility in everything you’re doing when you have this much volatility. That way you can focus on making the most amount of money you can, doing what you do.
Question 3 – Trust Provisions That Preserve Drive Rather Than Replace It
Stephan Shipe: I’m working on a trust structure for my kids who are in their twenties. I want to make sure my kids have the desire to succeed and not just live off their inheritance. So I’m adding a clause to their trust — it can’t be their primary source of income. One of my friends mentioned that they have a trust that stipulates their children must have a prenup, trying to make it easier on their kids to have the prenup conversation. Are there any other provisions I should think about adding?
This is a big one. It’s one where I think you’re coming from the right place, in the sense that — by far the most, and you’ve heard this before, listener to the podcast, we’ve had these types of conversations — one of the biggest concerns parents have about their kids is not that the money necessarily will ruin their life. It’s that the money will ruin their drive to do something else. So it’s never the exact — you’re not worried that you give kids money and they’re able to go buy a house. You’re worried that by you buying the house through the trust, that now they don’t have the drive to go work hard. They don’t have the experiences that you had to build up income. That’s always that friction that we face — you want to help out your kids, but you don’t want to help them too much. You want them to struggle a little bit, but you don’t want them to struggle too much. And it’s a fine balance. And so you’re not alone that you’re going through this balancing act of trying to say, I’m going to end up leaving my kids a significant amount of money, how do we do so so that way they still get up in the morning and have some purpose in life, and they can go do something.
So there are lots of ways to do this. And obviously I’m not an attorney, so you want to be jumping into this with an attorney discussion. But I can talk about what we’ve typically seen in the past, to give you some ideas to talk about with your attorney. I would be careful of making everything too concrete of what’s required. Because now you end up in a situation where you overengineer this whole plan, and it becomes like — I’m going to take advantage of every situation that could possibly come up. And it’s a one-size-fits-all, fits-no-one approach to estate planning, where you come up with all of these different contingencies. If my son does this, or my daughter does this, and what if they marry this person? What if they don’t have a conversation with this person? What if they’re working? What if they’re not working?
You put all these restrictions in place. And now you run into issues where there’s one weird circumstance that comes up, and now it doesn’t really fit them, and they can’t get the money out like they were expecting. We see this happen with education. We see this happen with different relationship requirements, right? You say, well, you can only have this money if you go to college, or if they’re using it for a college degree — and then one of the kids ends up going and founding a business that’s wildly successful, and now they can’t touch the trust. So are you going to make them go back to college now, just to check the box? You’re just adding a lot of boxes to check that you’re running the risk of overfitting the model, right? Which, from a statistical perspective, just means that you’re trying to hit everything, and at the same time you end up doing nothing.
So there are easier ones. What most people do — and one area which I really think you should consider — is that trustee discretion area. Find someone who’s a good trustee, have an independent trustee, and provide values guidelines. Is this what I’d like to happen? And allow a little bit more discretion there for that flexibility. So that way the trustee can make decisions and say, yes, this is in the spirit of what the trust is meant for, or this is not in the spirit of what the trust is meant for. And then you can stagger out distributions. You can have a certain amount of distributions at 30, at 35, at 40, at 45, or go in and have some matching. In other words, whatever is brought to the table, they’re allowed to take more out for a home down payment. So you can speed up some of the things, but you’re not paying for everything.
I would just be very concerned — what worries me is when you start getting into all of these different clauses, and then trying to put things in place, like the prenup discussion, prenup requirements, so that way now you’re bringing up the conversation. Why not just start those conversations with your kids now? Because in their 20s, it’s definitely time to start having these types of conversations, and starting to pass those values onto them of, hey, this is why a prenup may be important. This is what a trust is. This is why the restrictions are going to be there. Instead of planning for them to fail, start looking now and giving them the values, giving them the education, that financial literacy build-up today. So that way you have to worry about fewer boxes to be checked out in the future.
And I know that’s easier said than done. And maybe you’ve tried that, and you’ve gotten to the point where that’s not possible — then start adding some check boxes. And you can, and there’s no limit. Now, you go talk to your attorney, state-by-state laws will differ. But when you talk to your attorney, you can put whatever you want in there. And I’ve seen everything from drug tests to family voting to college education to where someone lives to who they’re living with — all of that can be included in there. Just remember, the more check boxes you’re requiring, the more you’re trying to really control those assets from the grave. And that rarely does well in current times, or for your reputation, even after you’re gone. So be careful there as you’re digging into those.
Outro
Stephan Shipe: That’s our show. Thanks for listening, and we’ll see you next week.
Disclaimer: The information provided in this podcast is for general informational and educational purposes only, and is not intended to constitute financial, investment, or other professional advice. The opinions expressed are those of the hosts and guests and do not necessarily reflect the views of any affiliated organizations. Investing in financial markets involves risk, including the potential loss of principal. Past performance is not indicative of future results. Before making any investment decisions, you should consult with a qualified financial advisor who can assess your individual financial situation, objectives, and risk tolerance.