A carefully selected retirement plan can provide financial security for owners and employees while lowering a practice’s tax burdens
Retirement statistics are dismal: fewer than half of Americans have calculated what they need to retire. Yet the average American spends more than 20 years in actual retirement. The personal savings rate is less than 5%. Most individuals do not save or accumulate money in a personal account.
A retirement plan offered at the workplace can help fill the gap or replace it completely. Which plan is right for you and your employees? Many factors must be considered. Is the main purpose to attract and retain quality staff? Are you looking for a tax deduction? Do you want the plan to be employer-funded only or will the staff be allowed to contribute through salary deferrals?
Smaller practices may want to first consider a Simplified Employee Plan (SEP) or Savings Incentive Match Plan for Employees (SIMPLE), both of which are Individual Retirement Accounts (IRA). They are relatively easy to establish and maintain, but eligibility and funding options are limited. A SEP offers a maximum eligibility of 3 years of service out of the previous 5 years. A year of service is credited to any employee that performs any service during the year, regardless of the number of hours worked. If you have part-time or seasonal employees who return each year, the plan could grow faster than expected. Eligibility requirements are minimal.
Funding the plan is optional each year. When you contribute you must give the staff the same level contribution as you give the owner. If you have many eligible employees, this plan quickly becomes too expensive in staff contributions.
There are many situations where a SEP plan works well: Offices with high staff turnover or recent acquisition of a practice/office are good examples. If you find yourself in a situation where a limited number of employees are eligible, this may be the plan for you.
What if your employees want to be more involved and contribute from their own wages to a retirement plan? A SEP does not allow for employee contributions, but a SIMPLE does. However, the SIMPLE’s eligibility requirements are more restrictive, as is the funding.
The SIMPLE’s maximum eligibility is 2 years of service. A year of service is credited for anyone who earned more than $5,000 during the year. Employees may contribute their own money to a SIMPLE on a pre-tax basis through payroll deductions up to a maximum set by the Internal Revenue Service each year. (In 2013 the limits are $12,000 or $14,500 for those age 50 or older.) These salary deferral options are available to the eligible owners and staff.
The employer must commit to annual funding in a SIMPLE either as a match or employer contribution. If the funding is an employer contribution, all eligible participants must receive 2% of their gross wages each year. If the match is chosen, then anyone that deferred must receive a match of up to 3% of their wages, but not more than the employee deferral. Hence, if the employee chooses not to defer a portion of their own wages, then there is no match from the practice.
Why look at the SEP or SIMPLE options first? Because the plans are easy to set up, participants control their own accounts and there are no added tax filings for these plans.
There are comparable plans to a SEP and SIMPLE in the qualified plan arena: Profit Sharing (PS) and 401(k) feature, respectively. The PS plan is similar to a SEP, in that it is funded entirely by the employer. Employee eligibility is based on hours rather than wages earned (typically set at 1,000 hours per year). The PS plan’s eligibility can be set to a maximum of 2 years of service, unless a 401(k) feature is added in which case the eligibility is limited to 1 year of service.
As with a SEP, PS funding is optional each year. In addition, certain plan designs, called comparability or cross-tested plans, allow you to contribute different amounts to different groups of participants. For example, owners and non-owner, and fund owners at 20% of their salaries and non-owners at 5%. The effectiveness of this plan design is created by a difference in the average age between owners and no owners.
Just like a SEP, the PS alone does not allow for staff contributions. By adding a 401(k) feature, however, an eligible employee can redirect a portion of his or her wages into the retirement plan through payroll deductions. Each participant decides how much to defer from his or her salary up to a maximum amount established by the IRS each year. (The 2013 limits are $17,500 or $23,000 for those age 50 or older.) The 401(k) feature can be designed to allow participants to defer on either a pre-tax basis for a traditional 401(k) or on an after-tax basis for a Roth 401[k].
Owners and/or other highly paid employees may be limited in their 401(k) deferral opportunities, because the amount the owner may defer depends on the amount that employees defer.
It is possible to avoid this testing limitation, but doing so requires an annual funding commitment very similar to the SIMPLE IRA: match or employer contribution. These options are referred to as a safe harbor 401(k). Many practices have used the safe harbor 401(k) to allow for maximum funding by the doctor. An owner looking to maximize his or her annual contributions may establish a PS with a 401(k) feature and fund up to the maximum set by the IRS each year ($51,000 or $56,600 for those age 50 or older for 2013).
Higher-earning practitioners may want to consider a Defined Benefit Plan (DB). A DB sets a pension level at retirement age and then requires an actuary to calculate what you must put in today to have enough in the future to pay out the promised pension. In essence it starts at the finish line and works backward to determine today’s annual required contribution.
The DB plan allows substantially higher annual contributions than the current $51,000 maximum permitted under a PS 401(k) plan. This plan design typically works best if you are 45 or older and your staff is further from retirement than you. The IRS sets an annual compensation limit, which for 2013 is $255,000. Anything above this threshold is ignored for retirement plan testing purposes. Staff costs can vary but typically range from 7.5% to 10% of wages in an optimum situation.
Unlike the SEP and SIMPLE, qualified plans have certain accounting, regulatory and third-party oversight requirements that must be satisfied. However, the benefits may far outweigh these costs. It’s important to understand the level of responsibility you assume as the plan sponsor and/or plan trustee.
Saving for your future is an important decision. Finding the vehicle that best serves your needs is critical, but you must first perform due diligence to make sure the plan fits your needs. The best retirement program will offer attractive features, prudent investments and overall cost-efficient administration. Most importantly it will help secure your financial future.