One of the most important decisions any business owner makes is what kind of retirement plan to set up for himself and his employees. This decision has far-reaching consequences in how much the owner is able to save for retirement, tax deferment, and business expenses. Not choosing the optimal plan can make a difference of hundreds of thousands of dollars in the long run.
This is especially important for physicians because of their above-average compensation. The first step in making such a crucial decision is understanding what the options are. In our upcoming blog series, “The Best Retirement Plans for Medical Groups,” we will examine the options available and their pros and cons. The most popular retirement plans that doctors establish in their practices are:
- Defined Benefit Pension Plans
- 401(k) Plans
- Defined Benefit/Defined Contribution Combination Plans
- Cash Balance Plans
This week, we’ll cover the strengths and weaknesses of the first type, Defined Benefit Pensions Plans
What is a Defined Benefit Pension Plan?
A Defined Benefit Pension Plan (DB plan) is a qualified retirement plan in which the participant is guaranteed a specific (“defined”) amount of money (“benefit”) upon retirement that continues until his death. The company that offers the plan funds it completely (employees do not pay into it) and has complete control over it, but also bears all of the risk.
An actuary is required to calculate how much the company must contribute to the plan in a given year and they are responsible for making up the difference if their investments perform poorly. Contributions to the plan are based on the participant’s age and compensation, so the company is required to pay in more money for older and more highly compensated employees.
What are the Advantages of a DB Plan for Physicians?
For physicians, a DB plan is an excellent way to defer income, reduce taxes and protect assets.
Contributions to a DB plan are considered a business expense, which means that they are not subject to taxation. Self-employed physicians can take advantage of the plan as a way to defer income and, therefore, reduce taxes.
How Much Can a Business Owner Save?
Let’s look at a 45-year-old currently making $250,000. Though an actuary is required to make the complex calculations for the exact amounts, it can be estimated that up to $78,000 can be invested into the plan on behalf of the employee. Contributing $78,000 to a DB plan allows a physician in the 33% tax bracket to defer over $25,000 in federal taxes.
Plan contributions are based on a calculation involving a participant’s age, compensation and promised benefit. For the year 2016, the IRS has set the maximum annual benefit to be paid at retirement at $210,000. That means that for older employees receiving the maximum benefit, the company could contribute even more than $210,000. A DB plan can be great for physicians because it allows by far the greatest tax-advantaged contribution towards retirement out of all the plan options.
Other Factors to Consider
Defined Benefit plans also provide another benefit for physicians who are at risk of malpractice suits. The Employee Retirement Income Security Act of 1974 (ERISA) guarantees that the pension is exempt from the reach of creditors through bankruptcy, meaning that no lawsuit, however great, can touch it. Under a DB plan, the pension is protected.
What are the Drawbacks?
While it can be a wonderful option for physicians, a DB plan is not a good option for businesses with inconsistent revenue. DB plans must exist for at least three years, so businesses must know that they will have the revenue available to contribute to the plan for at least those years. If the ability to contribute for three straight years is in question, there are more flexible plan options available.
For more information on DB Plans and whether they may be appropriate for your clients, contact me today at 480.494.8992 or by email at info@ff401k.com. Stay tuned for our next blog post covering the pros and cons of 401(k) plans for physicians.
About Kenny Phan
Kenny Phan is a Managing Partner at FinancialFocus Retirement Plan Services, a 3(16) fiduciary. He works as a pension specialist who partners with financial professionals to design and implement pension plans. His area of expertise is customized defined benefit, defined contribution, and 401(k) plans. Serving financial advisors and businesses in the greater Phoenix area, he is supported by FinancialFocus Retirement Plan Services. Together, they provide comprehensive plan design consultation, administration, document installation, compliance testing, as well as IRS and DOL reporting for qualified retirement plans.