Today's Practice: Planning for Retirement
How prepared are you to maximize your new options and benefits?
To view table related to this article, please refer to the print version of our July/August issue, page 59.
Medical practices, like many other businessses, struggle with offering cost-effective retirement benefits for employees and owners. Retirement plans can be an important compensation component and can even be a competitive advantage in attempting to retain key employees. The 2001 Federal Tax Bill (EGGTRA) has increased some contribution limits and catch-up provisions for those older than 50, and it made strategies like ?family income splitting? potentially more attractive (consult your tax advisor). In addition, the ever-increasing use of technology has made implementation and administration of these plans very reasonable, even for small businesses. If you already have a tax-qualified retirement plan, recent enhancements may mean your plan is not maximizing its potential benefits.
INCOME TAX BENEFITS OF TAX-QUALIFIED RETIREMENT PLANS
Most people understand the value of putting money away on a pre-tax basis through a tax-qualified retirement plan, but a closer look at the specific federal income tax benefits of qualified retirement plans is warranted. Employer contributions to a qualified retirement plan are immediately tax-deductible within prescribed limits. Employer contributions are not currently taxable to the employee until the money is distributed. This includes contributions made for the owner/employee. Certain plans allow for salary deferral of employee wages, which are also pre-tax contributions for the employee, including the owner-employee. And, as funds grow through interest earnings and investment returns, no taxes are payable on these earnings until they are taken as plan distributions.
To qualify for this tax-favored treatment, all retirement plans must, at a minimum:
• be written and communicated to employees;
• be for the exclusive benefit of employees and their beneficiaries;
• be permanent, but not necessarily irrevocable;
• prohibit the assignment or alienation of benefits to creditors;
• meet minimum participation, coverage, vesting, contributions and funding standards, which vary from plan to plan;
• and not be discriminatory in favor of highly compensated employees
Retirement plan assets are, in general, going to be put away until retirement (age 552 or 59) at the earliest, according to the IRS. Although there are ways to get at these funds sooner, such as loans or Substantially Equal and Periodic Payments, you should presume (and counsel employees) that these are funds meant for long-term financial security. Because there are tax benefits to these plans, there are also tax penalties to withdrawing funds before that time.
Employers that wish to offer or revise a retirement plan will quickly realize that the multitude of options and choices of retirement plans can be confusing. The first thing to determine is what type of plan is needed. Table 1 presents a breakdown of some important features that an employer will want to consider in deciding which plan may be best. Some states have exceptions to the general rules described here. Consult your advisor for advice specific to your situation.
DEFINED BENEFIT PLANS
A Defined Benefit Plan promises a stated benefit at retirement or provides a benefit according to a fixed formula. The employer bears the cost of the plan contributions, plan administration, and investment risk. Annual employer contributions can sometimes fluctuate widely and generally must be determined by an actuary or other financial administrator. Investment performance must be closely monitored and projections made so the employer knows how much to contribute to provide the retirement income promised under the plan.
Who Uses Defined Benefit Plans? Small businesses that use defined benefit plans are often firms with older, higher paid employees who are owners or shareholders. If there is not much time to build a substantial retirement fund for key employees (including owners) and the company has the financial ability to fund the plan, a Defined Benefit Plan can be a good choice.
DEFINED CONTRIBUTION PLANS
The purpose of a Defined Contribution Plan is to set aside funds to the individual accounts of participants based on an established contribution formula. A Defined Contribution Plan provides for either employer or employee contributions; sometimes both are allowed. Defined Contribution Plans can alleviate the burden on the employer of selecting investments for each participant, and the attendant fiduciary risk that this involves. With the uncertainty of investment returns, not to mention each employee having his own risk tolerance and investment horizon, many employers find it attractive to let employees direct their own accounts, usually subject to the set of choices the employer offers. This shifting of the investment burden to employees has made these types of plans very attractive to employers. As you choose a plan provider, be sure to ask if they are prepared to help you educate your employees in this area. The most common Defined Contribution Plans are detailed below.
Money Purchase Pension Plans
Under this Defined Contribution Plan, only employer contributions are allowed, which are usually based on a percentage of each employee’s compensation—say 10%. The employer is required to make these annual contributions. Employers favor the predictable costs and the fact that they can either be set-up to allow the employer to direct the investments, or to allow employees to direct their own investment account.
Who Uses Money Purchase Plans? Employers who want a company-funded plan and may require vesting options or other custom drafted options. The employer can direct the investment decisions or pass that responsibility on to the employees. These are also practices that have a very stable and predictable cash flow because the contributions are mandatory. These plans can be either off the shelf, so-called “prototype” plans with very low cost and limited flexibility, or custom drafted plans that allow some customization.
These Defined Contribution Plans are similar to Money Purchase Pension Plans, however, the employer is not obligated to make contributions each year, but there must be recurring and substantial contributions. When designing a Profit-Sharing Plan, the employer has great flexibility in determining how and when contributions will be made. For example, contribution amounts could be (1) based on profits that exceed a certain amount, or (2) a percentage of net income, or (3) determined by a board of directors each year. Not-for-profit organizations can also adopt a profit-sharing plan by indicating that profits (or surplus) will not be considered in determining the contribution level. Employer contributions to a profit-sharing plan are deductible but limited to no more than 25% of the total compensation of participating employees.
Who Uses Profit-Sharing Plans? Practices that want vesting options and other customizable features with the flexibility to make contributions when the employer sees fit. Costs can be managed through a contribution formula that is based on profitability or the discretion of the board of directors. Thus, if you have unpredictable profits year after year, this may be the plan for your practice. These plans can also be an off-the-shelf variety or prototype plan with very low cost and limited flexibility, or custom drafted plans that allow some customization. In addition, Profit-Sharing Plans can be combined with Money Purchase Plans to provide a fixed annual benefit of up to 25%.
Simplified Employee Pension (SEP) Plans
An SEP is a special type of employer retirement plan under which employer contributions are made to separate individual retirement accounts established for the participants. Plan administration, record keeping, and reporting are dramatically reduced. However, because many employers want to see their employees saving for themselves, and because the SEP plan is entirely employer funded (just like the Money Purchase and Profit Sharing Plans), many employers have favored Simple Retirement Plans and 401(k) Plans as an alternative.
Who Uses an SEP Plan? Employers who want low-cost, employer-funded but employee-directed accounts, and discretion each year as to funding. Options are limited and vesting is immediate.
SIMPLE Retirement Plans (Savings and Incentive Match Plan for Employees)
A plan for employers with 100 or fewer employees that allows employee salary deferrals (Money Purchase, Profit Sharing, and SEP Plans are all 100% employer funded; therefore, this is the first plan reviewed that allows employee salary deferrals). The employee can defer up to $8,000 for 2003, and the employer is required to match that contribution at 3% of salary for those employees saving at least that amount.
Who Uses SIMPLE Plans? Practices who need a straightforward, low-cost plan that allows employee salary deferrals, with a low required employer match—typically 3%, which could even be reduced temporarily if business conditions warranted.
The SEP and SIMPLE plans are not technically “tax-qualified retirement plans,” but are similar to a tax-qualified retirement plan and are available under differing IRS rules. One key difference is SIMPLE and SEP Plans do not fall under the auspices of the Employee Retirement and Income Security Act (ERISA), whereas the other tax-qualified retirement plans do.
Section 401(k) Plans
In section 401(k) plans, an employee can defer a portion of his or her compensation, and many employers elect to match all or a portion of the amounts deferred by employees. In addition, the employer may contribute an elective profit sharing contribution. Sole proprietors and partners with employees may also sponsor and participate in 401(k) plans. In addition, recent changes have combined to allow highly compensated individuals to defer up to a combined total of $40,000 per year into either a sole participant 401(k) or other combination type plans; thus, these funds can be very substantial. There is a 401(k) available for single participants in a prototype format at most custodians, or safe-harbor plans, that allow minimum employer contributions. The 401(k) plan is now so flexible and cost effective that almost any company or sole practitioner could have one.
Who Uses the 401(k) Plan? Anyone from a sole practitioner to the largest of organizations can now utilize the benefits of the 401(k) plan because it is among the most flexible plans in existence. Employers like this plan because it allows employee salary deferral options, the possibility of matching that deferral at some level, and the option to combine a discretionary profit sharing contribution with the 401(k) plan.
HOW TO PROCEED
1. Determine what the practice can afford and what the physicians’ goals and objectives are. Is this primarily an employer-funded plan to retain and reward employees, or will employees or employee-owners want to defer a portion of their salaries? If you only need to put away $8,000 per year to meet your retirement goals, and your employees would not choose to save more than that, why look at plans with greater savings limits?
2. Determine what level of features you want in your plan. For example, what options exist for: determining employee eligibility, contribution flexibility, vesting, loans, investment options, or consolidation of other retirement plans?
3. Evaluate the costs of various plans. Defined benefit plans and full-service 401(k) plans are typically the most expensive to run, easily costing $2,000 or more to start the plan for small employers, and a similar amount per year to run the plan. However, small group 401(k) plans are now available for as little as $500 to $1,000 per year. In addition, many custodians offer prototype plans with limited features, but at a greatly reduced cost. Be sure to look at total costs, including set-up, administration, actuarial fees, investment fees, and tax reporting fees (Form 5500), if applicable.
4. Get started! The sooner you or your employees start saving, the better. Consider this hypothetical example: If a 35-year-old saves $500 per month for 10 years, for total contributions of $60,000, and stops contributing his money could grow to $334,890 by age 65, at a 7% return. A 45-year-old contributing $500 per month for 20 years (from age 45 to age 65) for a total savings of $120,000, may only accumulate $260,463 at 7%. In other words, the 45-year-old had to save twice as much to accumulate 22% less money! (Your results may vary.)
Whatever age you start, it’s just like your health—it’s never too late to start making progress.
Michael P. Hatch, CFP, JD, is a Financial Advisor and Principal with The Sterling Group, a financial planning and fee-based investment manager, located in Southern California. The Sterling Group is affiliated with Linsco Private Ledger, (member SIPC), the largest independent brokerage firm in the U.S. Mr. Hatch specializes in working with entrepreneurs and professional practices, assisting them in defining and implementing their financial, philanthropic, and intergenerational planning strategies. He may be reached at (626) 440-5995; firstname.lastname@example.org.