Q: What is the best retirement plan for your professional practice?
A: Doctors and lawyers typically don’t have the cost structure that many other industries have. As opposed to manufacturers or distributors, professional practices typically have very little property to depreciate. Depreciation is essentially a cost to the company that is only on paper, and does not represent a true cash expense.
Businesses that own machinery and property to build, store, or deliver a product can expense those items over years, which reduces profit, but not necessarily cash flow. As depreciation reduces profit, the business’s taxes are reduced. However, for most professional practices, cash flow is profit, and taxes owed on that profit can create large cash burden for successful practices.
Because of the structure of the business, professional practices should take every available step to defer income and minimize taxes.
If you’re a professional in a partnership or your own practice and would like to take steps to maximize the amount income (and taxes) you can defer, consider establishing a company-sponsored retirement plan. Many practitioners are hesitant to establish a plan due to complication, perceived cost or perhaps it’s just not a priority.
If you are one of these professionals, you should find that the time and effort to establish or improve your current retirement plan will be rewarded.
Retirement plans are usually either IRA-based or “qualified,” like a 401(k) plan. There are benefits to each, but in general, more income can be deferred in a 401(k) and they can provide more flexibility.
However, 401(k)s are generally more complicated, which means you will likely need a third-party administrator, or TPA, to help you comply with federal regulations.
This is an added cost, but TPA rates from small businesses have become very reasonable, some charging annual fees of less than $1,500. Under some plan structures, all the fees can be paid at the participant level, rather than corporate.
THE POPULAR 401(k)
The 401(k) plan has become a hugely popular retirement savings vehicle for small businesses. According to the Department of Labor, an estimated 48 million American workers are enrolled in 401(k) plans with total assets of about $2.4 trillion. With a 401(k) plan, employees can make pretax and/or Roth contributions in 2011 of up to $16,500 of pay ($22,000 if age 50 or older).
These deferrals go into a separate account for each employee and aren’t taxed until distributed. You can also make employer contributions to your 401(k) plan – either matching contributions or discretionary profit sharing contributions. Combined employer and employee contributions for any employee in 2011 can’t exceed the lesser of $49,000 (plus catch-up contributions of up to $5,500 if your employee is age 50 or older) or 100 percent of the employee’s compensation.
SAFE HARBOR PLANS
Because 401(k)s are subject to certain federal regulations to prevent employees from being treated unfairly, many business owners choose to adopt a “safe harbor” 401(k) plan.
With a safe harbor 401(k) plan, you generally have to either match your employees’ contributions (100 percent of employee deferrals up to 3 percent of compensation, and 50 percent of deferrals between 3 and 5 percent of compensation), or make a fixed contribution of 3 percent of compensation for all eligible employees, regardless of whether they contribute to the plan.
Your contributions must be fully vested; which means the business can’t have it back if the employee leaves.
SIMPLE IRA
For businesses with fewer than 100 employees, the Simple IRA plan is an option.
Both employers and employees contribute to this plan, such as in a 401(k), but employee contributions are limited to $11,500 of pay ($14,000 if age 50 or older). Business owners must either match employees’ contributions dollar for dollar — up to 3 percent of each employee’s compensation – or make a fixed contribution of 2 percent of compensation for each eligible employee.
(The 3 percent match can be reduced to 1 percent in any two of five years.) SIMPLE IRA plans are easy to set up and administrative costs are low.
SEP-IRA PLAN
A Simplified Employee Pension, or SEP, plan allows you to set up an IRA (a “SEP-IRA”) for yourself and each of your eligible employees. The business contributes a uniform percentage of pay for each employee, although you don’t have to make contributions every year, offering you some flexibility when business conditions vary.
The downside to a SEP is that the employee does not contribute anything. For 2011, your contributions for each employee are limited to the lesser of 25 percent of pay or $49,000. This is a popular plan for individuals who are self-employed. SEPs have low start-up and operating costs and can be easy to establish.
Get answers to financial questions on Wednesdays from our columnists who work in the financial services industry. Travis Flenniken, CFA, is vice president of investments with DeMoss Capital — demosscapital.com. Submit questions to his attention by writing to Business Editor John Vass Jr., Chattanooga Times Free Press, P.O. Box 1447, Chattanooga, TN 37401-1447, or by e-mailing him at jvass@timesfreepress.com