Some recent revisions in pension laws are allowing dentists to feel more comfortable about the state of their retirement savings
James R. Pride, DDS, and
Brian Hufford, CPA, CFP
The years 1999 and 2000 have brought about dramatic pension law changes that offers opportunities for you to greatly improve your retirement savings. These changes are quite complex but, with a little help, you can easily implement the new pension rules in your practice. The purpose of this article is to illustrate the changes and mo-tivate you to find help in designing and implementing a great pension plan.
The lack of significant retirement savings among dentists is an enig-ma. Our firm recently completed a three-year study of more than 300 new dental clients from approximately 45 states. On average, these solo dentists had very successful practices with gross production of about twice the national average. However, the retirement savings of these profitable dentists averaged about $12,000 per year. The average age of this group was 43. If the retirement savings and realized investment returns were projected to age 65, adjusted for 3 percent inflation in living costs, a retirement lifestyle of only $25,000 to $35,000 per year would be achieved.
Contrast this reality with the opportunities offered by the tax code and investment returns over the past 25 years. During this period, the law has allowed any self-employed doctor to contribute 25 percent of pay (or $30,000 a year) to a tax-deductible pension plan with investment earnings that grow on a tax-deferred basis. For the most recent 25 years, the S&P 500 Index has averaged an investment return in excess of 17 percent per year. So, a 65-year-old dentist today who, at age 40, began funding a pension at the $30,000-per-year level and who had invested in an S&P 500 index fund, would have accumulated more than $8.7 million in 25 years. The annual cost to achieve this result was only about $18,000 per year of "real" after-tax dollars in the combined 40 percent federal and state tax brackets. Even 25 years ago, a monthly saving in a dental practice of $1,500, yielding the $18,000 annually, was very achievable.
Why then have so few professionals used the maximum retirement-plan benefit offered by the tax code? There are three reasons. The first is that the staff-to-doctor ratio in a dental practice causes staff costs to be unreasonable in the easiest-to-implement retirement plans. In a productive dental practice, the doctor`s salary may be only about 50 percent of total salaries. If the doctor implements a straight percentage-of-pay pension plan, then he or she might have to spend $30,000 for staff retirement benefits to achieve a $30,000 self benefit. In other words, the doctor would have to spend $60,000 to achieve a $30,000 retirement saving for himself or herself. Other non-pension savings might produce a better result.
The second reason is that many dentists use retirement plans such as Simple Plans and SEP-IRA accounts, which do not allow the doctor to save the full $30,000 per year. Yes, these plans are very easy to implement with very low costs to administer, but the loss in ultimate retirement savings is unacceptable.
The third reason is the perception by the dentist that there just isn`t enough money after living expenses to save in a retirement plan. Many dentists wait until their late 40s or early 50s to get serious about saving for retirement. With historical equity investment returns, waiting just five years to begin saving at age 40 can cost an individual more than $1.4 million of retirement accumulation at age 60. The best time to start saving $30,000 per year is right now. Nearly every dentist we counsel feels that his or her family spends too much. Typically, this is not the problem. By restructuring their financial picture, most dentists can save more than they think possible without a change in lifestyle.
This article will illustrate how recent pension law changes can eliminate the first and second reasons, and how doctors who need to catch up because of the third reason can avail themselves of higher pension savings.
Younger doctors - in their 30s to early 40s - have had the most difficult time achieving a reasonable staff-to-doctor retirement-savings benefit. The reason for this problem is that most pension plan designs skew contributions through an age-weighting mechanism to achieve a better result for the older dentist. Younger dentists often cannot benefit from age disparities between themselves and their staffs. In 1999, the pension law was amended, allowing the doctor to reduce staff pension costs by 40 percent, on average, without using age. The amendment was to 401(k) plans. The new type of plan is called a "safe-harbor" 401(k) plan. Section 401(k) of the tax code allows individuals to save and deduct their own retirement dollars in addition to what the "employer" contributes for them. This provision currently allows an employee to save and deduct up to $10,500 for the year 2000.
Haven`t doctors always been allowed to do this? Theoretically yes, but 401(k) plans rarely gave the doctor a good result. Why? The law limited the doctor`s ability to save the full $10,500 because the doctor was restricted in what could be saved based upon what the staff saved. If the staff did not participate in saving, the doctor was severely limited. Frequently, the doctor was only able to reach about two-thirds of the $30,000 goal with a 401(k) plan / profit-sharing plan combination for this reason.
The new safe-harbor rules allow the doctor to contribute a full $10,500 if one of two minimum benefits are provided for the staff. The most commonly used minimum benefit is providing eligible staff members with a 3 percent safe-harbor contribution. Following is an illustration of how this new provision might be used to reduce staff retirement costs. First, let`s look at the difficulty of achieving a good result for a 35-year-old doctor in an integrated money-purchase pension plan (see Chart 1).
In this case, the doctor has achieved the savings goal of $30,000. However, the plan is somewhat expensive with $19,289 of staff costs. The doctor has just barely been able to achieve the same after-tax savings of 60 percent that would have been achieved without the pension plan, but the staff is receiving the money instead of the IRS. With staff forfeitures created from vesting rules and with the tax-deferred growth allowed within the plan, this still is a reasonably good result.
Notice the improvement offered by the new safe-harbor 401(k) provisions, using the same sample practice, in Chart 2.
With the new safe-harbor 401(k) plan, the doctor has been able to cut staff costs by about 37 percent from $19,289 to $12,090, while retaining the same $30,000 personal savings goal. The "3 percent minimum" savings for staff is included in the safe-harbor contribution. In this case, we have not illustrated any staff savings in the 401(k) element of the plan to keep the example from being confusing. However, one of the advantages of this type of plan is that the staff would be able to contribute deductible savings of their own as well, unlike the money purchase plan. The only disadvantage of this new plan is that it is a little more difficult and more costly to administer than the simpler types of retirement plans. However, the savings in staff costs should easily justify it.
This is great for younger doctors, but what about older doctors who have larger discretionary income and an accompanying higher income-tax bracket? These doctors may need to catchup on retirement savings or may simply wish to avoid income taxes while saving larger amounts for retirement.
The year 2000 has brought the best pension news in years. Congress repealed Section 415(e) of the tax code, effective Jan. 1, 2000. This provision had, in effect, limited an individual to one pension benefit during his or her life. Allow us to illustrate why this repeal is big news.
Assume that a doctor is 55 and wishes to contribute the maximum amount allowable on a tax-deductible basis to a pension plan. Can he or she contribute more than $30,000? Yes, thanks to the defined-benefit pension plan, which limits the ultimate benefit that can be provided instead of the annual amount contributed. This ultimate defined-benefit limitation is the same for everybody. However, the older doctor has less time in which to accumulate the ultimate benefit; therefore, the annual contributions allowed are much higher. Doctors who are over age 44 can contribute more than the $30,000 per year allowed in defined-contribution plans.
For instance, the 55-year-old doctor probably can contribute a maximum of roughly $101,000 per year to a tax-deductible, defined-benefit plan. This could save $30,000 to $40,000 per year in income taxes! If this doctor`s staff members are in their 20s and 30s, the dentist could achieve this savings while maintaining as much as 90 percent or higher of the total benefits accruing. This is due to the age disparity in contributions. The ideal retirement savings strategy would be to contribute $30,000 per year as soon as possible for doctors younger than age 45, and then to switch to a defined-benefit plan to achieve the larger deductions. Section 415(e) limited this strategy by mandating that doctors were required to count past contributions to all plans during the doctor`s lifetime. This greatly limited what could be contributed to a defined-benefit plan.
With the repeal of Section 415(e), doctors now can fully fund a defined-benefit plan, even if they have made significant contributions to other plans in the past.
There is simply no excuse now for failing to save a significant amount of money for your retirement. If you are younger, the law offers new retirement-plan strategies, which allow extremely attractive results. For older doctors, the pension law allows you to catch up rapidly while saving large amounts of federal and state income tax.
Likewise, qualified retirement plans offer much flexibility on how benefits may be received during retirement. There are simple methods to avoid the 10 percent penalty for withdrawals before age 59 1/2, and the 15 percent "success tax," which penalized excess pension accumulations, has been repealed.
For more information about this article, contact Dr. Pride at (800) 925-2600 or Mr. Hufford at (317) 848-4987. The authors` biographies appear on page 12.