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Make the most of pension law changes


Recent changes make it important to review your retirement plan now--or start one if you don't already have one. Here are the key questions to ask.


Make the most of pension law changes

Recent changes make it important to review your retirement plan now—or start one if you don't already have one. Here are the key questions to ask.

By Peter M. Zebot

Nine words sum up the many changes in the pension law over the past couple of years: Your retirement fund will grow faster and last longer. Whatever your age, you'll be able to step up your deductible contributions while in practice and shield more of your stash from taxes after you quit.

Early in 2003, the government presented additional proposals intended to encourage saving for retirement. Their fate is uncertain, but that needn't stop you from making the most of the opportunities already at hand. To do that, you may have to adopt a new plan, modify an existing plan, or discard one that has served its purpose. The questions that follow help point out ways to maximize your benefits.

What plans should I consider for a new practice? The first choice is generally a discretionary profit-sharing plan, but if you're a young doctor you may find a Simplified Employee Pension (SEP) attractive to start. A recent change in the law raised the maximum deductible SEP contribution from 15 percent of compensation to 25 percent. However, the employer is free to contribute a smaller percentage and vary it from year to year, as the state of the practice's finances dictates. Although a standard profit-sharing plan, which has similar contribution limits, can include provisions to hold down the cost of employee benefits, a SEP is less complicated to administer.

Setting up a SEP is easy—just fill in a few blanks on Form 5305-SEP, give the plan participants copies, and have them establish IRAs in their names at the financial institution of their choice. (Don't forget to do this for yourself, too.) The IRA custodian gives the participant an annual account statement and notifies the IRS of its year-end value. You file no reports and have no responsibility for the investment or distribution of the funds, except for those in your own IRA.

Another plan that's a breeze to administer is appropriately named SIMPLE (Savings Incentive Match Plan for Employees). This plan would let your employees voluntarily reduce their 2003 compensation by up to $8,000 and contribute it tax-free to an individual IRA. You must make a small matching contribution for each participant. Compared with a SEP, your savings on plan costs could be substantial, but there's a drawback: You, too, can contribute only $8,000 plus 3 percent of compensation for yourself.

Should I add a 401(k) to my standard profit-sharing plan? Do the math before you decide. The 2003 dollar limit on deductible contributions for a profit-sharing plan participant younger than 50 is $40,000. If your practice is incorporated, you'll fall short of that unless you're paid at least $160,000, because the maximum corporate contribution rate allowed is 25 percent of salary. So if your salary is only $120,000, say, the corporation can't contribute more than $30,000 to your account in an ordinary profit-sharing plan.

That's when a 401(k) provision may come to the rescue: Assuming the antidiscrimination rules permit (see below), you can bridge the gap by making an "elective" 401(k) contribution (up to $12,000 in 2003) from your salary. In the previous example, you might put away $10,000, reducing your taxable salary to $110,000. But thanks to a benevolent amendment to the pension law, the corporation could still base its contribution on your full salary of $120,000. As a result, the total set aside for your retirement would consist of $30,000 in the profit-sharing account plus $10,000 in your 401(k) account, equaling the $40,000 legal limit. The 401(k) option is available even if you're self-employed, although the arithmetic differs somewhat.

What if the antidiscrimination rules cramp my style? Rising salary deferral limits could make this problem more vexing as time goes by. Present law will let a doctor defer up to $15,000 by 2006, and inflation indexing may raise this amount thereafter. However, if lower-paid employees in a practice aren't willing to make proportionate deferrals, the plan may fail an antidiscrimination test, reducing the amounts doctors can contribute for themselves. You may be able to overcome this hurdle if your plan provides a generous matching program for employee contributions.

The law does allow some forms of preferential treatment. For instance, a profit-sharing plan can be "age based" or "tiered" by job classification, channeling a bigger share of the pie into the accounts of older and more highly paid participants than a conventional plan permits.

If your employees, on average, are substantially younger than you and your existing retirement fund needs supercharging, you might be wise to favor a defined-benefit plan. It generally allows contributions large enough to provide an annual pension equal to a participant's salary, based on the three consecutive years with the highest earnings. The plan must treat all eligible employees alike, but the lion's share of the contributions will be for your benefit, since you have less time than the other participants to build the projected retirement nest egg. What's more, in some circumstances, you could achieve an even better result by maintaining a profit-sharing plan in addition.

How do I change my 401(k) plan to take advantage of the new "catch-up" rules? Amend it to allow participants to increase their salary deferrals by the catch-up amounts, starting the year they turn 50. For example, the deferral limit for 2004 will be $13,000 plus a $3,000 catch-up. Suppose your plan caps regular deferrals at 10 percent of salary in order to meet the antidiscrimination test, and as a result a participant earning $110,000 may defer only $11,000. If he'll be at least 50 next year, the plan can let him defer up to $3,000 more, for a total of $14,000, without affecting the test.

Catch-up limits are only half as high for SIMPLE plans—$1,500 in 2004, instead of $3,000.

Can I safely tap my pension fund in case of a financial bind? That's a good question, because making the larger plan contributions the law permits could leave you (or your employees) short of cash for health emergencies, home purchases, and tuition costs, just to name a few possible contingencies. The law normally penalizes participants for withdrawing funds from their retirement accounts when they're younger than 59 1/2. The most practical way to avoid premature distribution troubles is to update your plan to include certain exceptions specified in the regulations, such as withdrawals attributable to an employee's disability or for qualified higher education expenses. That's easily said but not so simple to do, even though recent revisions in the law help some. Bear in mind that the rules vary depending on the type of plan and whether it's tied in with a 401(k) or an IRA.

You can also escape penalties by borrowing from your plan and repaying the loan in the manner prescribed by another set of regulations. If you want to go that route, your plan must permit such loans. Some don't, especially in unincorporated practices; until last year, such practices could have a loan program only for participants who aren't owners. If that's true for your plan, think about amending it to offer a nondiscriminatory loan option for doctor-owners and staff alike.

Can I roll over existing IRA funds to my practice's plan? The law now permits retirement plans to accept IRA transfers, with limited exceptions. (Formerly only a plan payout previously put into a "conduit IRA"—could later be rolled into a different plan.) Combining all your retirement assets in one place could make them easier to manage and increase the amount you might be able to borrow from the plan. Moreover, getting your funds out of IRAs can help safeguard them from creditors. However, the transferred funds would be subject to the plan's rules on how and when you can take distributions.

Can my employees hold me responsible if plan investments perform poorly? Yes, unless participants direct their individual investment accounts. Even then, the plan must give them at least three broad choices to diversify risks—say, via stock, bond, and money-market mutual funds. Participants must also receive enough information about each alternative, such as prospectuses and financial reports, so that they can make sound decisions.

If the plan doesn't provide for self-directed accounts and you're the trustee, you'd best obtain professional guidance. But be aware that merely relying on a broker's recommendations won't get you off the hook if the plan performs poorly.

In the wake of the Enron debacle, bills are pending before Congress to encourage plan sponsors to rely on independent investment advice. Consider beating them to the punch by hiring a manager registered with the SEC and requiring him to accept fiduciary responsibility. Have him prepare an investment policy for the plan in writing and distribute copies to all participants.

As for your own nest egg, early on it probably won't be large enough to warrant paying an adviser to manage the investments for you. If you're a novice investor, consider putting your money into a mutual fund tied to a broad market index like the S&P 500, and maybe pairing it with a short-term bond fund to yield some income with comparatively little risk. You're not likely to go too far wrong with such a combination. Also, investing small amounts at regular intervals can offer some protection against short-range market reversals.

Given the larger contributions I can now make to my profit-sharing and 401(k) plans, should I shed my second defined-contribution plan? Probably. When the profit-sharing contribution limit (including deferrals) was 15 percent of earnings, you could raise the overall contribution to 25 percent only by adopting a second (money-purchase) plan, committing you to an additional 10 percent contribution. Since that's no longer necessary, you can transfer the money-purchase assets to your profit-sharing plan. The IRS says this conversion isn't subject to normal termination rules that could require your plan to immediately pay out the assets to participants.

Aside from the extra record-keeping chores and administrative expense an auxiliary money-purchase plan entails, eliminating it will also relieve you of the obligation to contribute a stated percentage to it come rain or come shine. With a profit-sharing plan alone, you can lower the percentage if you decide that the money you'd save on contributions for your employees is worth more than the personal benefits you'd lose. If you like, you can even reduce the profit-sharing percentage to zero in any year, while still maintaining the 401(k) feature.

How can I hold down taxes on my post-retirement benefits? Your plan should include options to stretch out withdrawals over as long a period as the law allows—or to take as much as you need to enjoy your retirement. Regulations generally require a plan to pay benefits in the form of a life annuity to you and, if you're married, to your surviving spouse after you die. But the plan may let you waive this (with your spouse's written consent) in favor of any alternative method specified in the plan or approved by the plan's trustee.

Legally, you don't have to begin taking benefits until after you reach age 70 1/2, and a regulation issued last year substantially slows the pace of mandatory withdrawals, so that the bulk of your pension fund continues to grow tax-deferred. On the other hand, you could cease practice much earlier without abandoning your pension tax shelter.

If you're between 55 and 70 1/2 when you quit practice, you're free to take distributions from your fund as you wish or leave it intact. If you quit when you're younger and want to begin withdrawals sooner, you'll have to comply with special annuitization rules for five years or until you turn 59 1/2, if that's later. Another new regulation makes those rules less burdensome if investment losses deplete the fund.

What if you can't predict which option will suit you best when the time comes, or your employer balks at including your preferred choice in his plan? If the plan lets you take your account in a lump sum, as most plans do, when you retire you can instruct the plan administrator to transfer the money into an IRA of your choice. Pick one that offers the withdrawal option you prefer.

Should I replace my individually designed plan with a prepackaged one? Possibly. Revisions of the pension law and regulations in recent years frequently entail complex amendments of existing plans to protect against disqualification for noncompliance. By adopting a master or prototype plan, you shift the onus of updating it to the plan preparer or issuer—usually a bank, investment firm, insurance company, or retirement services organization. But in return for administrative convenience and possible cost savings, you may have to forgo some desirable features like age-weighting and accept others you don't want, such as a limited investment menu. Study competing proposals carefully, since you can't "customize" the plan on your own without risking disqualification.

The author is president of PMZ Pension Corporation in Aliso Viejo, CA.


Peter Zebot. Make the most of pension law changes. Medical Economics May 23, 2003;80:24.

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