PRACTICAL CONCERNS: Retirement Remedies for Physicians

Jonathan Leidy, CFP(R)

The Employee Retirement Income Security Act (ERISA) limits doctors and other individuals who earn more than $115,000 per year from fully contributing to their retirement plans. Indeed, for doctors who earn more than $250,000 per year--the “maximum compensation” as defined by the Internal Revenue Service--the ability to contribute to retirement plans is often capped. No matter what they earn, physicians need creative solutions to ensure that they are aptly prepared for retirement.

ERISA-qualified solutions that have become increasingly popular over the past few years include cross-tested or New Comparability profit-sharing plans, as well as Cash Balance plans. In addition, many physicians are turning to non-ERISA-qualified plans, when additional flexibility is desired.

DB vs. DC

ERISA outlines two basic retirement plan types: defined benefit and defined contribution. Defined benefit (DB) plans are characterized by a known retirement income or “benefit,” such as 75% of the average of your last three years’ salary. In order to generate the collective retirement income of all the DB participants, an omnibus account is funded each year. The amount of that funding is variable, depending on the current age and earnings of each participant, as well as several assumptions regarding future investment returns and salary growth. If the return in a given year is greater than expected (or salary growth is less), the amount of the following year’s contribution decreases; the converse is also true. In that way, DB plans have a known benefit, but an unknown contribution.

The exact opposite is true for defined contribution (DC) plans. With a DC plan, the amount put in each year is known. The funding source is employer contribution (profit sharing), participant contribution (salary deferral), or a combination of both. Permissible amounts are subject to ERISA ratios and caps, but the contribution is a known quantity. What is unknown in a DC plan is the balance of a participant’s account at retirement.

Historical abuses at companies like Studebaker and Bethlehem Steel led to a mass migration away from DB plans in favor of DC alternatives. Unfortunately, DC plans have been an abysmal failure from an overall retirement preparedness standpoint, and they have placed significant strain on physicians who are attempting to save for retirement.

So what retirement remedies are available for physicians? The answer depends on several factors, primarily the nature of the doctor’s employment. Enter Dr. Freelance and Dr. Salary, both of whom are in the 50s. Dr. Freelance is a self-employed physician who has either created her own practice or has banded together with like-minded physicians to form a group practice. Dr. Salary is an employee who works for a large medical group or hospital foundation.

Dr. Salary’s options

For Dr. Salary, the retirement options can be limited. In most cases, he is at the mercy of his employer when it comes to determining which plan types are offered and to whom. Dr. Salary’s lack of flexibility, however, can be somewhat counterbalanced by the scale and negotiating power of his employer.

Dr. Salary’s employer will most likely provide a 401(k) plan, which allows for tax-deferred savings of up to $17,000 per year, with an additional $5,500 per year in permitted contributions, since Dr. Salary is older than 50. Dr. Salary’s employer may also offer to match his salary deferrals up to a certain maximum percentage of compensation contributed, such as 5%. Matching contributions represent “free money” for Dr. Salary, and he should capture them whenever possible.

Another option for Dr. Salary, assuming his 401(k) plan permits it, is to make Roth 401(k) contributions. Whereas regular 401(k) contributions are made pre-tax, Roth contributions are made post-tax. At retirement, both the contributions and earnings of a Roth account can be removed tax-free. Given that higher future tax rates seem virtually certain, paying taxes now in exchange for the opportunity to take tax-free retirement distributions likely represents a good trade-off for Dr. Salary, and perhaps makes even greater sense for some of his younger colleagues. And unlike the standard Roth IRA, which has income participation limits, anyone can contribute to a Roth 401(k).

Dr. Salary’s retirement plan may also have a profit-sharing feature. Unlike the salary deferral of a 401(k), profit-sharing contributions are made by Dr. Salary’s employer. These contributions are usually discretionary, and in combination with his salary deferral, catch-up contribution and match, can total as much as $55,500.

It is also common for large medical employers to provide DB plans for their employees. Although a DB plan represents an excellent opportunity for Dr. Salary to earn a retirement income stream, his participation in the plan is compulsory, with no active decision to save on his part.

Lastly, Dr. Salary may be offered non-qualified savings opportunities, including deferred compensation or 457 plans. These are non-ERISA plans and, unlike DB/DC plans, the assets within them are subject to the general claims of his employer’s creditors. Deferred compensation plans represent a decent way to smooth income across Dr. Salary’s retirement threshold. However, the possibility of his employer defaulting makes them a somewhat risky alternative.

Dr. Freelance’s options

For the self-employed Dr. Freelance, the opportunities for retirement savings are more plentiful. She can sponsor most of the plans detailed above, and in doing so, act as both the employer and the employee. This nuance is significant because it affords her the flexibility to control the contribution sources to her account, and thus maintain greater control of her plan’s total funding cost.

Beginning again with the standard 401(k) plan, whereas Dr. Salary can maximally defer $17,000 of his earnings this year (plus the additional $5,500 for being over 50), Dr. Freelance can contribute up to $55,500. While Dr. Salary is also entitled to additional contributions from his employer, he is utterly dependent upon his employer to make those contributions, and the combined total can’t exceed the $50,000 limit plus the $5,500 catch-up.

For Dr. Freelance, maxing out is easier. When she acts as both employer and employee, her individual 401(k) or Solo(k) allows her to make the maximum contribution of $55,500 with virtually zero compliance headaches. Her Solo(k) also allows her to include her spouse as a plan participant.

When Dr. Freelance takes on additional partners or employees, her retirement situation becomes more complex. ERISA testing rules now come into play that may limit her ability to contribute the maximum amount. The purpose of these rules is to prevent discrimination against rank-and-file employees. As a result, Dr. Freelance and other highly compensated employees (HCEs) who make more than $115,000 per year often cannot even approach the maximum contribution limit.

Dr. Freelance may need to retool her retirement plan to increase her tax-deferral opportunities. One common change she can make is to introduce a Safe Harbor 401(k), which allows employers and employees to make matching contributions to the plan. The match needs to at least equal 4% of salary and be open to all employees. However, the contribution only needs to be made for those employees who actually participate. If Dr. Freelance’s staff has a low participation rate, she can max out her own contributions with a relatively reasonable overall funding burden.

Dr. Freelance’s other Safe Harbor option is to make a non-elective retirement contribution to all eligible employees at 3% of salary. If most of her staff is inclined to capture the match anyway, the flat 3% is likely the better option. This version of Safe Harbor solves the deferral limitation issue, but the funding cost can be quite high.

New Comparability plans

In addition to the above, Dr. Freelance’s retirement options also include New Comparability and Cash Balance plans. New Comparability plans are useful when there is a wide spread in age among the individuals in Dr. Freelance’s group. Some may be just a couple years away from retirement and have plenty of income to make a retirement plan contribution. Others may be putting their twins through college and have little disposable income. Standard profit sharing requires the same contribution percentage is applied across all employees. A New Comparability plan, however, allows Dr. Freelance to split her practice into groups, each with its own distinct contribution percentage.

The most basic grouping is owners versus non-owners, whereby the average age of each cohort is compared against the participants in the other group to develop the profit splits. New Comparability plans allow Dr. Freelance and her younger partners to collectively receive a larger portion of the profit-sharing pie, while rank-and-file employees, even older ones, will receive less.

Physician groups often add a third tier to delineate between younger and older owners. This configuration allows for the younger, potentially more cash-strapped docs to take the bulk of their share of profits as current compensation, while Dr. Freelance and her contemporaries can max out their retirement contributions.

It has even become common practice to place each employee in their own distinct group. Doing so allows for maximum flexibility when determining profit-sharing contributions, and prevents Dr. Freelance from having to amend her plan every time an employee leaves.

As with any retirement program, New Comparability plans have their drawbacks. The formulas that govern these plans are intricate and require set-up and maintenance costs. In addition, New Comparability plans are still required to pass all the standard discrimination tests applicable to ERISA plans. Perhaps most important, employee turnover can wreak havoc on plan testing. If Dr. Freelance has a 10-person practice and two of her younger support staff leave, the average age of her rank-and-file group will rise, which will in turn require that a large portion of the profits go to the non-owners.

Cash Balance plans

In all the examples above, one thing remains constant: the maximum that Dr. Freelance can contribute--taking into account the sum of her profit sharing, matching and salary deferrals--is $55,500 per year (the sum of her $50,000 annual limit plus $5,500 per year for being over 50). Is there a plan that allows her to save even more? The answer is yes--a Cash Balance plan.

A Cash Balance plan is actually a hybrid DB/DC plan that uses the same actuarial formulas prevalent in DB plans. Unlike traditional DBs, the target benefit at retirement is not an income stream, but a specific balance. With a Cash Balance plan, Dr. Freelance can target a specific ending value for her retirement account and determine her annual contributions through actuarial calculations that take into account her age and prevailing interest rates.

Cash Balance plans make sense for practices with older doctors and younger staff. Steady cash flows are also critical, because the plans need to be funded for at least three years in order to avoid IRS scrutiny. In addition, the return on the deferred capital from prior years affects the amount of future contributions. Above-average returns in the early years of the plan simply translate into curtailed future contributions. This feature often has doctors (and their retirement plan advisors) making relatively conservative asset allocation decisions within Cash Balance plans.

A converse argument can be made if the cash flow of the practice is robust. Early investment success means money is mounting in the tax-deferred Cash Balance plan more quickly. Thus, any surfeit earnings in future years that otherwise would have been required contributions to the Cash Balance plan can simply be treated as standard profit. Conversely, if near-term investment results are poor, more of the practice’s future cash flows can be directed toward the Cash Balance plan.

In either case, Dr. Freelance is accepting 100% of the funding risk. To the extent that she is comfortable with her future cash flow projections, she can afford to take more risk for the chance to maximize her tax-deferral opportunities.

As with several other retirement options, Cash Balance plans work best in the absence of older, rank-and-file employees. Specifically, the “risk-on” strategy described above can be far less desirable in cases with many such employees, as Dr. Freelance is effectively insuring a greater amount in near-term payouts. That noted, should Dr. Freelance default, her participants’ benefits are protected by the Pension Benefit Guaranty Corporation.

Cash Balance plans also need to offer retirees the option of receiving their benefits in the form of a lifetime annuity. This risk, however, can easily be transferred to an insurance company by securing a single-premium, immediate annuity at retirement. Standard DB pension plans can be converted to Cash Balance plans through amendment. The rules specific to conversion are manifold, but the option makes sense for some sponsors.

Summary

Doctors face several challenges when saving for retirement. Although ERISA caps often limit the amount that doctors can defer under standard arrangements, other options exist. Dr. Salary’s options relate more to understanding the various plans available to him and maximizing his deferred savings by deftly shifting among them. Capturing all matching contributions and considering the Roth 401(k) option will also be important for him.

For Dr. Freelance, the opportunity set is wider. She can turn to a number of plan design options to help maximize her retirement savings. If her practice has older doctors and younger staff, a Cash Balance plan may make sense. If she has younger doctors in her group, a New Comparability plan may represent a better choice.

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Mr. Leidy is a principal at Portico Wealth Advisors in Larkspur.

 

Email: Jonathan@porticowealth.com