Choose the right retirement plan for you and your practice

There is no single right plan for every practice, but a few pointers can guide you to the best choice for you.

Kenneth W. Rudzinski

I cringe every time I hear members of Congress use the phrase “tax simplification” when describing the latest Washington version of “making sausage.” Let us be honest: The U.S. Tax Code is not, never has been and never will be “simple.”

And nowhere is the complexity of the tax code more apparent than in the sheer number of qualified retirement plans available to individuals, whether through their employer or on their own, and to business owners and medical professionals.

A partial list of retirement plans includes the traditional IRA, Roth IRA, Roth 401(k), Simplified (there’s that word again) Employee Pension or SEP-IRA, Simple IRA, 401(k), safe-harbor 401(k), solo 401(k), 403(b), 457 plan, profit-sharing, and so on. Toss in an array of nonqualified plans, such as deferred compensation plans, salary continuation plans, executive bonus (Section 162) plans, and the retirement plan landscape broadens even more.

As a financial planner, I am often asked what retirement plan best suits a particular client, especially a medical professional. Whether you are self-employed with or without employees (other than your spouse) or are part of a multiphysician practice, whether you are a doctor who is employed by a hospital or perhaps work in a commercial setting such as a Wal-Mart either as an employee or as a self-employed consultant, the best type of plan or combination of plans is hardly self-evident. No “simplification” here.

In order to answer the question, I usually run through a mental checklist of important criteria, the answers to which serve as a homing beacon through the maze of retirement plan types, to arrive at the one or two best alternatives. Then it may simply be a matter of the individual’s preference.

The purpose of this article is to share with you that general pathway.

Traditional and Roth IRAs

To begin, let us assume that you are self-employed or a solo incorporated practice, or you are in a small multiphysician practice. I always start with the question, “How much money do you want to contribute to a qualified retirement plan?”

If the answer is $4,000 to $5,000, then either a traditional IRA or a Roth IRA will do, and there is no need to complicate your life further. Between those two plans, the younger you are, the greater your preference for tax-free distributions at retirement, and the less need for an up-front tax deduction, the better the Roth IRA will work for you.

Here is a caveat for Roth IRAs, however: If you are married and file jointly and your MAGI (adjusted gross income plus tax-free interest income) exceeds $166,000 in 2007 ($99,000 for single taxpayers in 2007), you cannot contribute to a Roth IRA in that tax year. Those phase-out limits do not apply for traditional IRAs, except in the case of a spousal IRA.

If you are covered by a qualified plan at work but your spouse is not, your spouse can have a traditional or Roth IRA subject to these phase-out limits. Other limits may apply, so you should check with your tax advisor to make sure you stay within the income rules.

Bottom-line advantage

A bottom-line advantage of using just your own IRA outside the business is that no employer contributions or matching for employees are required. Truly simple.

If you desire to set more money aside for retirement, then other plans may be more attractive. The Simple IRA permits you in 2007 to contribute up to a $10,500 flat (ie, not a percentage of pay) deferral from your pay plus $3,000 for age 50-plus catch-up. A 401(k) permits $15,500 in 2007 plus another $5,000 age 50-plus catch-up. If your practice has no other employees except your spouse, a solo 401(k) can be used with the same deferral amount permitted in a regular 401(k) but with significantly reduced annual administration costs.

Simple IRAs and 401(k)s, however, require the participation of employees after an appropriate eligibility period, and contribution amounts for you as owner may be reduced in a regular 401(k) depending on how much your employees do or do not contribute. This is not so in a Simple IRA, where the opportunity to contribute to your own account is not dependent upon the level or frequency of employee contributions. This is the same with a safe-harbor 401(k), where employee contribution levels do not dictate contribution levels of the owners or highly-compensated employees. The tradeoff in the safe-harbor 401(k) is usually 100% immediate vesting for matching contributions (see below) and a mandatory matching formula.

So if your practice employs staff who are eligible to participate in your qualified retirement plan but who may not contribute their own money, and if you seek higher contributions than individual or Roth IRAs will allow, then a Simple IRA or safe-harbor 401(k) may be your best alternatives.

Matching contributions

Matching contributions are permitted but are not mandatory in a regular 401(k); they are not allowed in a solo 401(k) (not needed there), but they are a requirement in a Simple IRA. The most frequently used matching formula in a Simple IRA is a dollar-for-dollar match up to 3% of pay, which can be lowered to 1% in any 2 of 5 years. For a normal 401(k), the most common match I have seen by employers is 50% of the first 6% of pay, so the maximum match is limited to 3% of payroll of those deferring money into the plan. The match is voluntary and can be changed by the employer, but only prospectively, not in arrears.

The safe-harbor 401(k) requires a 100% match on the first 3% of pay and 50% of the next 2% of pay contributed by employees. So an employee contributing 2% gets a 2% match; another contributing 5% or more gets a 4% maximum match. The tradeoff for you is that you can put your $15,500 (plus $5,000 age 50-plus catch-up amount) into the safe-harbor 401(k) regardless of the level of employee contributions.

SEP-IRAs, on the other hand, are funded entirely with employer dollars. The maximum percentage of pay is 25%, except for unincorporated owners, whose contribution is limited to 25% of net profit, which is defined as profit reduced by contributions for both owners and employees. So a solo practice, self-employed practitioner would be limited to a contribution of $20,000 on $100,000 of net profit (which in IRS-speak equals 25% using the following formula: ($100,000 – $20,000)/$100,000 = 25%).

In a SEP-IRA, however, you must contribute for eligible employees the same percentage of pay that you contribute for yourself, so dropping 25% of your pay into the plan requires 25% of pay for employees. For self-employed, your 20%, according to the IRA, equals 25%, so your employees would get 25% of pay. The maximum dollar limit for contributions for tax-year 2007 is $45,000. If you have employees, a SEP-IRA may work if you really want to reward those employees for hard work and sweat equity.

Eligibility

Let us talk about eligibility. The SEP-IRA allows you to exclude employees younger than 21 years old, or who make less than $500, or who worked for you less than 3 of the preceding 5 years. Simple IRAs can exclude employees who earned less than $5,000 in any 2 preceding years and are expected to earn less than $5,000 in the current year. 401(k)s can exclude employees younger than age 21 and who have less than 1 year of service or who work less than 1,000 hours. In all cases, union employees and nonresident aliens may be excluded regardless of age or length of service.

So while SEP-IRAs contain a high contribution percentage for employees, the plan allows you to exclude high-turnover employees. SEP-IRAs can be great if you work in a hospital but have consulting income on the side, especially if you do not have any employees other than your spouse. You can contribute to a 401(k) at the hospital for your W-2 hospital income and have a separate SEP-IRA for your consulting income in addition.

The nice thing about Simple IRAs is that your contribution is not a percent of pay but a flat contribution. Actually, the only reference to percent of pay with the Simple IRA is that you can contribute up to 100% of your pay. Also, the 3% match is not prohibitive and can be limited to only those employees who contribute their own money to the plan: ie, employees who value retirement.

In both SEP-IRAs and Simple IRAs, there is no administrative burden, unlike a 401(k) in which a plan administrator is required with a corresponding level of expenses to maintain the plan. A solo 401(k) requires less administration and therefore much lower fees.

Vesting, deadlines

Vesting means “ownership,” and it indicates the right of employees to keep some or all of employer contributions on behalf of those employees. Those could be matching contributions, as in a Simple IRA or 401(k), or direct contributions as in a SEP-IRA. In a normal 401(k), the vesting can be gradual, such as 20% per year of service, but in Simple IRAs and SEP-IRAs vesting is 100% and immediate, as it is in a safe-harbor 401(k). In other words, in Simple IRAs and SEP-IRAs, when employees leave, they take their own money (which is always 100% vested) plus the money you have contributed to their accounts as employer.

In my experience, vesting is not usually an issue that ultimately decides the best plan for you.

While Simple IRAs and 401(k)s must be established before the end of the tax year (Simple IRAs require 60-day employee notice), SEP-IRAs can be set up and funded as late as the time you file your income taxes, including extensions. So SEP-IRAs are ideal for after-the-fact setup and funding. Elective deferrals for Simple IRAs and 401(k)s come from payroll deduction during the tax year. Matching can occur along with payroll deductions or in a lump sum by the time of the due date for the employer’s tax return. SEP-IRA contributions can be delayed until employer tax filing due date or can be funded throughout the year, depending upon your preference.

The accompanying charts summarize what type of employers might be candidates for which plans. The information is courtesy of The Hartford, a multinational investment and insurance firm.

In summary, when considering what type of qualified retirement plan might work best for you, you must consider your own reasons and objectives for wanting to set one up. How much you want to contribute for yourself and for your employees, how much or little you want to pay to administer the plan, how long you wish to exclude employees, to what extent you want to permit employees to make contributions of their own, are all valid criteria for determining the right plan for your practice. You should seek the expertise of a financial planner or tax advisor who understands the rules for qualified retirement plans and who can guide you through the ever-expanding maze of plan choices.

If you send me an e-mail, I will send you a more detailed chart of the characteristics that will make the best retirement plan choices for you.

For more information:

• Kenneth W. Rudzinski, CFP, CLU, ChFC, CASL, is a registered representative of Lincoln Financial Advisors Corp., a broker/dealer (Member SIPC) and a registered investment advisor in Wilmington, Del. He has been cited in Money magazine and in Who’s Who in Finance & Industry. He can be reached at The America Group, Foulkwood Professional Building, 2036 Foulk Road, Suite 104, Wilmington, DE 19810; 302-529-1320; fax: 302-529-1324; e-mail: kenneth.rudzinski@lfg.com. Lincoln Financial Advisors Corp., or its representatives, do not give tax or legal advice. The information in this article is from sources deemed reliable. This information should not be construed as legal or tax advice. You may want to consult a tax advisor regarding this information as it relates to your personal circumstances. CRN# 200702-2003274.