Qualified retirement plans for doctors through their dental practices represent one of the biggest opportunities for future financial security.
Hugh F. Doherty, DDS, CFP
Qualified retirement plans for doctors through their dental practices represent one of the biggest opportunities for future financial security. However, many doctors are missing out because 401(k) plans have been recommended to them, without a consideration of other types of qualified plans. This is, unfortunately, poor and costly advice. Profit-sharing, money-purchase, and target-benefit plans let doctors shelter much more of their income than a 401(k) and provide more flexibility in rewarding employees.
In the U.S., 200,000 new qualified retirement plans will be established in 2000. Most of them will be set up by business owners with fewer than 100 employees, like dental practices. The most disturbing statistic is that 60 percent of practices do not have a retirement plan at all! Worse yet, many doctor-owners do not foresee implementing a plan in the near future.
Since retirement plans are so advantageous, it is puzzling why every doctor-owner wouldn`t want one! Of course, some young practitioners aren`t yet profitable enough to fund a retirement plan, but many doctors of established, profitable practices aren`t interested, either.
One reason is that many of them aren`t counting on a retirement plan to fund their "golden years." Some plan on drawing profits from their practice during retirement by selling the practice. There is one bit of advice I can offer: Don`t count on the sale of your practice to fund your retirement. This is a serious mistake!
A retirement plan, however, can offer the best path to a secure retirement. Consider the plight of a profitable practice: The doctor-owner can reinvest profits in the practice, but may already be reinvesting the most that is allowable. Taking out more money in salary or bonus drives up income taxes. For most doctors, it`s wise to put the money in a qualified plan to get a tax deduction now and tax-sheltered growth for the future.
Starting with the basics, a qualified plan offers specific tax advantages by reducing a participant`s current tax bill. In addition, the money a participant defers into investments grows without any tax assessment until taken out of the plan. By then, the doctor no longer will be working and likely will be in a lower tax bracket.
The 401(k) is complex in nature
The doctor-owner may be interested initially when someone proposes a plan, but often loses interest when the details and complexity of a 401(k) are revealed.
Let`s say Dr. Joe, who is age 58, plans to retire at age 65. He has struggled to build his practice for years - now it`s turning a $75,000 annual profit. He pays himself a $150,000 annual salary. He learns that $10,500 a year is the most he currently can contribute to a 401(k) plan. This cap is adjusted upward slightly by the Internal Revenue Service each year to offset inflation. That`s just not enough to make a big difference for his retirement, he concludes, especially when weighed against the additional cost that the plan might not be right for him. Remember, the employer match - the percentage the doctor (employer) kicks in to match employee contributions - has to be the same for all employees. While lower-paid employees wouldn`t hit the $10,500 limit, Dr. Joe would, and, therefore, he would contribute a lower percentage of his salary to the plan than for his employees.
He decides that while a 401(k) plan might benefit his employees, it wouldn`t do enough to help him meet his personal retirement goals. Dr. Joe loses interest and rejects it.
Instead of a cookie-cutter 401(k) plan, Dr. Joe needs a customized plan that meets his specific needs. Just as every individual has different personal needs requiring a customized financial plan, every professional practice is distinct and needs a customized pension plan. With a solid understanding of the doctor-owner`s needs, a pension professional - called an actuary - can design a plan that meets those needs precisely.
Advantages of a qualified plan
Profit-sharing, money-purchase, and target-benefit plans offer several major advantages over the 401(k).
First, most of these plans let doctor-owners contribute up to $30,000 a year to their retirement plan, substantially more than they could contribute in a standard 401(k). Contributions are tax-deductible.
Second, a much higher percentage of the contributions can go to the business owner`s account than to the employees` accounts. Consider Dr. Joe and his three employees - see Figure 1. An age-weighted, profit-sharing plan lets almost 88 percent of the practice`s plan contributions go to the doctor`s retirement account. With a standard 401(k) plan, only 48 percent of the total contributions are for the doctor-owner.
Third, these plans offer more flexibility to reward key employees. Age-weighted profit-sharing plans and target-benefit plans let the practice contribute more for older employees who have been with the business longer. A retirement plan is an incentive that helps the business attract and retain good workers, who are at a premium in today`s tight labor market.
The final advantage is simplicity. While these plans may sound complex, in actuality they are not. They are only a bit more expensive to administer than a 401(k). All of these plans are defined-contribution plans, which are much simpler to administer than the older defined-benefit plans that required expensive actuarial work annually. The cost of administering retirement plans has plummeted in recent years, thanks to technology. A plan with five to seven members now can be administered as cost-effectively as one with 500. The secret is to find a good actuary.
One bit of caution: Don`t let your investment advisors tell you that they can do the actuarial planning. They just don`t have the expertise. We have specialists in our profession; therefore, you need special advice as to which plan is the "right one" for you.
What are the alternatives?
One is the SIMPLE plan, which comes in two varieties: the SIMPLE IRA and SIMPLE 401(k). They are available to doctor-employers. As the name implies, these plans are very simple to administer. They are exempt from nondiscrimination rules that apply to ordinary 401(k) plans. However, they are somewhat inflexible and have lower deferral limits.
With these plans, the employer must make either a matching or a "nonelective" contribution. The employer can match the employee`s contributions up to 3 percent of the employee`s compensation. Alternately, it can make a nonelective contribution of 2 percent of compensation for all eligible employees.
Both varieties limit employee contribution to $6,000 annually. However, with the SIMPLE 401(k) only, the employee and employer generally can make a larger combined contribution: up to $6,000 from the employee, plus the 3 percent match. For instance, the doctor-employer match for someone making $150,000 would be $4,500, so the total maximum contribution would be $10,500.
Various types of profit-sharing and money-purchase plans provide the doctor-owner with more flexibility and the ability to make higher contributions. With a standard money-purchase plan, the business contributes (and deducts) up to 15 percent of compensation for all eligible employees, up to a limit of $30,000 a year. This percentage is fixed. The employer must contribute the same percentage every year. A profit-sharing plan works somewhat similarly. I am not in favor of money-purchase plans, as they have not been the best for our clients.
Profit-sharing plans can be nonintegrated or integrated. With a nonintegrated plan, the maximum contribution for any one participant is the lesser of $30,000 or 25 percent of compensation. However, the maximum deduction the employer may take is 15 percent of compensation. The employer can vary that percentage each year.
An integrated profit-sharing plan has some actuarial differences that allow a slightly higher allocation of contributions for the doctor-owner and a greater share of the total contributions for the owner than the standard profit-sharing plan. Again, the maximum contribution for any one participant is the lesser of $30,000 or 25 percent of compensation. However, the doctor-employer`s contribution percentage is fixed and cannot be varied from year to year.
You can combine a 401(k) and profit-sharing plan. This gives the business owner more flexibility and the ability to shelter more money. It lets the practice contribute up to 25 percent of an employee`s compensation, up to a limit of $30,000. Typically, the practice would contribute a fixed percentage to the 401(k) plan and up to 15 percent to the profit-sharing plan.
Two other types of plans let the practice reward the older, higher-paid employees - such as the doctor. With an age-weighted profit-sharing plan, the funding limit is 15 percent; however, the practice doesn`t have to contribute the same percentage for all employees. It can contribute a lower percentage for younger employees with fewer years of service. This type of plan often can provide the maximum benefit for the business owner. The majority of our clients are in this type of plan. Look at Figure 1 again and see why. If you would like more information on the age-weighted, profit-sharing plan, contact me by e-mail: [email protected].
A target-benefit plan also favors older employees. It sets up a "target" benefit based on a formula. The target benefit, in turn, determines required contribution levels, again up to a maximum of $30,000 or 25 percent of compensation.
While it`s good for doctors to know about the various plans in broad outline form, there`s no need to try to become an expert on them. A good actuary can meet your retirement-plan needs by proposing and ultimately administering the plan for you. Those who follow this advice can put away serious money for retirement. Even a relatively small business like your practice can build up a large balance in its retirement plan over the years because of the additional contributions made every year. The tax-deferred assets keep growing and growing.
One final note: Most doctors? mindsets have changed from saving to investing, which is great. However, they must be prudent investors with their retirement money. That money is tax-advantaged because the government rightly understands it is in society?s best interests for self-employed individuals to have a nest egg when they stop working.
For that reason, everyone should invest with a strategy ? no puts/calls, options, commodities, derivatives, or buying on margin ... but, rather, with a strategy that has a strong likelihood of long-term success.