When it comes to money, there’s only one thing more complicated than the tax code, and that’s the rules surrounding qualified retirement plans. While they may be complicated, these plans are simply the best way for surgeons to beat the tax man at his own game.
No qualified plan is more powerful than a defined benefit plan, and no plan is more poorly understood. Here’s a primer to help you get started.
A defined benefit plan is an employer sponsored retirement plan that promises to deliver a specific or “defined” amount of money or “benefit” to an employee beginning at retirement and lasting for the rest of their lives. Traditionally known as “pension plans,” defined benefit plans have been around for decades. Actuaries—the bean counters who design and administer these things—refer to them collectively as “DB plans” and the most recent incarnation of the DB plan is called a “cash balance plan.”
No matter what you call it, the DB plan is a wicked sharp tool for deferring income, reducing taxes and protecting assets.
Every dollar that goes into the plan is a dollar that your employer (that’s you, if you’re self-employed) does not pay out in profits, which means that income is not taxed today. If you’re a surgeon aged 45 earning $210,000 or more, you can receive contributions to your plan of up to $112,000 in 2014 (twice as much as you could contribute to a combination 401(k)/profitsharing plan). At age 55, you can receive contributions of more than $200,000. Given taxation in the 35 percent Federal marginal tax bracket, surgeons taking advantage of a DB plan are deferring somewhere between $39,000 and $70,000 in taxes every year.
Note the use of the passive voice, here. We did not say “you can contribute.” We said “you could receive contributions.” This is one aspect that sets the defined benefit plan apart from the more familiar defined contribution plans (like 401(k), 403(b) and profitsharing plans). You, as an employee, have precisely zero control over a DB plan. It all rests in your employer’s hands. They decide how much you can defer, how it will be invested and whether or not you can participate. If you’re not selfemployed, you might as well stop reading here because there’s literally nothing you can do about a DB plan.
If you’re self-employed, though, meaning you’re a partner, shareholder, LLC member or sole practitioner, there are a few things you need to know.
- Contributions to your DB plan are based on your employee’s age and compensation. Older, more highlycompensated employees (typically the surgeon owners) will require greater contributions, while younger staff with lighter wages will get less.
- You cannot game the system so that only the owner-employee benefits. The IRS has strict rules about who must be covered and more rules that prohibit discrimination. A skilled actuary may be able to tilt the playing field in your direction, but you must know that your employees will be treated equitably by your plan.
- A DB plan requires commitment. While there is no hard and fast rule about how many years you must keep your plan in operation, actuaries generally advise employers to keep their plans open for at least five years, and to keep those plans active/funded in at least three of those years. This means you need to have a reason to believe that your practice will have sustainable positive cash flows in the foreseeable future.
These general guidelines paint a picture of which practices should, and which should not, adopt a DB plan.
The best fit scenario we have seen was a group of four radiologists who had no employees. Two of the physicians were in their early 60s, with one junior partner in her mid 40s and one newly hired physician on track to become a partner. They all earned mid-six-figure incomes. Collectively, they could have socked away more than a half million dollars a year.
The worst fit scenario typically involves younger physician owners with highly-compensated physician extenders, a plethora of older support staff and a hazy or fragile bottom line.
However, some scenarios that seem like a poor fit for a DB plan might be salvageable. Particularly in situations where the employer has a safe harbor defined contribution plan, like a combination 401(k)/profit sharing plan where the employer is already making generous contribution to each employee’s account. In such a case, it might be possible to dramatically increase the overall contributions to owner-employees while only slightly increasing the share of plan benefits received by employees.
Beyond the tax benefits, DB plans are hugely helpful for surgeons in subspecialties with high rates of malpractice. As entities governed by the Employee Retirement Income Security Act of 1974 (ERISA), they are exempt from the reach of creditors through bankruptcy.
If you decide to explore the option of adding a DB plan to your practice, there is no substitute for a consultation with a pension guru. It is customary for pension actuaries to run a complimentary analysis of your practice to let you know whether or not a DB plan might be right for you. This analysis is usually free of charge.
While the rules surrounding DB plans are painfully complicated, there is no reason to fear what you do not at first understand. The potential benefit is so enormous that you owe it to yourself—or at least you owe it to the next partner who brings this idea into your executive committee meeting—to ask questions and listen to the answers so that you can understand all the costs and benefits to know whether or not a DB plan is a good fit for your practice.
W. Ben Utley, CFP®, is an attending advisor with Physician Family Financial Advisors, a fee-only financial planning firm helping physicians throughout the U.S. to make a plan and get on track with saving for college and invest for retirement.