Investing Vehicle Updates for Modernity

By Steven Podnos; MD, MBA, CFP®

Most physicians count on their retirement plans for the bulk of their financial security. Yet, few of us understand the intricate workings of these plans, and are therefore misled or at the least miss out on a number of cost savings and benefits. Here are some examples to consider, especially during this time of financial upheaval:

1. Jim L, an endocrinologist in private practice, works with his wife as office manager and has four other employees.  Jim had a “free” prototype profit sharing plan with a well known brokerage and has been putting 15% of his total employee compensation away every year in order to fund about $35,000 dollars a year into his own plan.  He pays his wife $60,000 dollars a year in order to get a $9,000 dollar annual contribution for her, but at a social security cost of the same $9,000 dollars.  His plan is invested in a variety of “loaded” mutual funds and stocks at the brokerage, and he was not really sure how it was doing in terms of performance.

Change:

The plan was changed to a customized 401k/profit sharing plan using a Third Party Administrator at a cost of 2500 dollars.  Jim’s wife lowered her salary to $20,000 dollars, which saved over $5,000 dollars a year in social security taxes.  Yet Jim and his wife were now able to contribute over $65,000 dollars in pretax money (rather than $44,000 dollars in prior years.  His employee cost for the plan dropped from 15% of a $100,000dollar payroll to 6%, another annual savings of $9,000 dollars. 

2. Statewide Healthcare medical group had an insurance based “retirement” plan.  All of the investments allowed were wrapped in variable annuity/insurance wrappers with an annual expense ratio of between 2 and 4% annually. The plan was “free” to the group but did not allow any differentiation in benefits or contributions between the physicians and their employees

Change:

An unbundled 401k/profit sharing plan was designed that allowed physicians to contribute the maximum in salary deferral and profit sharing contributions. Using an age-weighted contribution formula, the physicians were able to put away 14% of their salary in the profit sharing plan as compared with a 5% contribution for employees.  The new investment portfolios carried an annual cost well below 1% annually and were actively monitored by a fee only fiduciary advisor, mostly relieving the group from the fiduciary responsibility for the fund investments.

3. Kirk L, an orthopedic surgeon employed his wife and 5 employees in a busy practice.  He is 55 years of age and looking towards retirement in ten years.  He had a reasonably well designed 401k/profit sharing plan advisor which let him and his wife put away about 70-75 thousand dollars a year with an employee cost of about 15 thousand dollars. He was beginning to worry about not having enough savings to make his retirement goal.

Change:

Kirk and two of his younger employees were switched to a new Defined Benefit plan, but also continued in the 401k salary deferral plan. Kirk’s wife and the remaining employees stayed in the old plan and his wife’s salary was reduced to lower Social Security costs.  With the new plan, Kirk and his wife are now putting away about $200,000 dollars in pretax contributions annually at a marginally higher cost for the employees.

Poorly Designed Retirement Plans

None of these stories are unusual, in fact they are typical.  Most physician retirement plans are poorly designed, expensive and misunderstood.  Few existing plans are updated to capture the many positive changes made in tax law over the last decade.  Many plans are shoddily designed to catch the “quick” dollar, with financially terrible consequences to the physicians.

Qualified Plans

And so, I’ll review the most common types of retirement plans available to medical practices and discuss the pros, cons and specific opportunities each type for most practices. Note that most of these plans are considered “qualified” plans by the US Government.  Being qualified means that contributions to the plans are allowed to be deducted as business expenses and that the plan assets are generally protected from creditors.  In exchange, the government requires extensive paperwork and mandatory contributions for employees on the lower end of the salary scale. 

1. SEP-IRA

The SEP-IRA allows a fixed percentage of salary (up to 25% of W2 income) to be contributed to individual IRAs of most employees (including the physicians). There can be no discrimination in what percentage of compensation is used between owner/managers and lower paid employees, making this a relatively expensive plan in terms of employee funding. There is no component of salary deferral by employees, and all plan funding is immediately “vested” (belongs to the employee immediately if they leave employment).

The advantages of the SEP plan include a minimum of paperwork and ease of setup. Generally, SEP-IRA plans are used by small family owned businesses with few to no outside employees. It does work well for physicians that act as Independent Contractors (no employees) such as many Emergency Room physicians.  However, an individual contractor with an income of less than around $170,000 dollars can actually put more pre-tax money away in a Self-Employed 401k plan.

2. SIMPLE-IRA

This plan is another relatively easy one to set up and administer. It allows companies that have less than 100 employees to open individual IRA accounts for employees. The employees may defer salary in amounts of $10,500-$13,000 (depending on age), and the employer supplies a “match.” All money in the plan is immediately vested. The match is generally (but not always) a dollar for dollar matching contribution of up to 3% of the employee’s compensation.

For example, a company owner with a compensation of 100,000 dollars would be able to defer salary in an amount of up to $13,000 (if age 50 or older), and then have the company “match” 3% or $3,000 more. A SIMPLE IRA plan is a good choice for small businesses in which the owners are highly compensated, and few employees wish to defer salary. The disadvantages of the SIMPLE-IRA are immediate vesting for the matched funds, and relatively low total amounts of contributions compared to other qualified plans. 

NOTE:

I have seen these plans work well in small practices that wish to avoid paperwork, have few to no employees that wish to defer salary, and who don’t mind the limited ability to make contributions.  Note one unusual feature of this plan, in that the 3% match has no limits. I have seen one physician with a small group of employees and an income of $600,000 dollars per year put away 13,000 in salary deferrals and another ($600K X 3%) 18K in the match at no employee cost!

3. 401k/PROFIT SHARING PLAN

This is by far the most common type of qualified plan in existence.  These plans actually have three components:

a)       401k salary deferral-In 2008, employees may defer between 15,500 and 20,500 dollars. This money and earnings on it are not subject to Federal income tax until withdrawn in retirement, and are immediately vested.

b)       A “match”-this is an optional part of the plan in which an employer may offer to contribute a matching amount of dollars to give employees an incentive to participate.  Matching funds are usually subject to vesting on a time schedule.

c)       Profit sharing-like the match, this is a discretionary contribution by the employer of up to 25% of payroll and usually subject to vesting.

It is crucial to have a skilled plan designer customize a 401K plan for your individual practice.  The most common abuse of these plans is the use of “cookie cutter” prototype plans used by brokerages and insurance companies. These prototype plans are for the convenience and profit of the person “selling” the plan, and are a solid negative for the practice. Customization allows the physicians to have maximal participation at the lowest employee cost.

There is also a self employed 401k option for small practices that have no full time employees other than the physician and spouse. They operate in much the same way, but with little expense and much less paperwork.

4. DEFINED BENEFIT PLAN

Once common, these plans are now rarely used by most companies. They are based completely on company contributions to a fund (no salary deferral) that are actuarially designed to produce a set benefit amount at retirement. All the risk for providing the promised benefit is the responsibility of the employer, which is an advantage when the major beneficiary is the physician. Defined Benefit plans work best for practices in which the physician/employee ratio is low and the physician(s) is approaching age 50 or older. The advantage of this plan is allowing much higher contributions on a pretax basis, with the disadvantage of higher administrative costs. These plans work extremely well for high income businesses employing one individual (plus or minus a spouse) who is nearing age 50 or over. However, physician practices that employ a spouse or physicians of different ages can often use a Defined Benefit Plan in conjunction with a 401k/profit sharing plan to great benefit as in example three.

Assessment

Doctors have a tremendous opportunity to review and enhance the retirement plan options. Although the article focuses on these medical professionals and related occupations, much of the material applies to other professional and business clients.  A relationship with a good Third Party Administrator [TPA] and some independent study are invaluable to your ability to perform this function well.

Conclusion

Dr. Podnos is a fee-only financial planner and the author of “Building and Preserving Your Wealth, A Practical Guide to Financial Planning for Affluent Investors” (available at Amazon.com and bookstores). He can be reached at Steven@wealthcarellc.com And so, your thoughts and comments on this Medical Executive-Post are appreciated.

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Filed under: Book Reviews, Financial Planning, Funding Basics, Investing, Portfolio Management, Retirement and Benefits, Taxation | Tagged: 401-k, 403-b, defined benefit plans, IRA, Podnos, retirement planning, SEP, SEP-IRA, SIMPLE, SIMPLE IRA | 2 Comments »