[Editor's Note: This is a guest post from Konstantin Litovsky, a financial advisor specializing in small practice retirement plans. While this is not a paid post, he is a paid advertiser on this site.]
At first glance, the only difference between small practice and large company retirement plans is the number of participants. Everything else would seem to be identical – both plans have a Third Party Administrator, a record-keeper, a custodian, an investment adviser, mutual funds, contributions to employees and individual participant accounts. Despite the apparent similarities, small practice and large company plans cannot be more different from one another. Understanding how small practice plans are different from large plans is important for small practice owners because most plan providers specialize in working with large companies and they are not capable of addressing the full scope of issues that small practice plans will encounter. In this article, we’ll explain how small practice retirement plans are different from those of large corporations, and discuss a number of important issues, including the types of services a small practice plan needs and the criteria that can be used by practice owners to select the best small practice plan providers.
Small Practice Demographics
Small practice demographics can have a significant impact on plan design, and any changes in practice demographics can require changes to the plan design, which is not true for large company plans.
1) A practice with a younger owner and older employees or an older owner and younger employees might require two very different plan designs, and if a younger owner hires an older employee the plan might need to be redesigned.
2) Adding family members to the payroll can have a significant impact on small practice plan design and has to be taken into account, especially if this happens after a plan has already been adopted.
3) Bringing in a partner might require a plan redesign if both partners want to participate. Even if a partner does not want to participate in the plan, they will still have to share in paying the plan’s administrative expenses and employer contributions.
4) Employees working for small practices, particularly younger, lower-paid employees do not typically make 401(k) salary deferrals. For this reason, small practice plans (but not large company plans) have to be Safe Harbor and provide either a 3% non-elective or a 4% elective match to employees. If the practice owner wants to maximize their 401k contribution by adding Profit Sharing, this will not be possible without the Safe Harbor. Often, low participation will require a plan to have a 3% non-elective contribution vs. a 4% elective match.
5) Small practices might have high turnover, and this, too will have an effect on plan design. Practice owners can limit the expenses associated with high turnover by adding a 6-year graded vesting schedule. Any money forfeited in this way can be used to make employer contributions to all of the remaining employees.
For a small practice, failure to update plan design might result in the plan failing testing which can lead to significant IRS penalties if the matter is not addressed promptly.
Plan Design and Architecture
When selecting the best plan design and architecture, small practices will require a much more comprehensive approach than do large companies. Because practice owners will get the most benefit out of the plan, small practice plans will need significantly more customization and support to find and implement the best solution.
1) Owners might want to maximize their contribution ($53k in 2015) while minimizing their expenses. Most large companies will end up with a basic 401k with just the salary deferral ($18k in 2015) and possibly a small elective match, while small practices can benefit from having a customized 401k with Profit Sharing or a Triple Match design.
2) Small practices don’t have the resources to overspend on their 401k plan. To get the best design, a design study has to be performed to take into account practice specifics and to estimate the potential cost of the plan in terms of employer contributions and administrative expenses.
3) Many small practices might benefit from a pooled plan vs. a participant-directed plan, which is more appropriate for large companies. A pooled plan eliminates the need for a record-keeper, and you can open a single pooled account directly at Vanguard to get access to low-cost Admiral Shares. A pooled plan is often a better choice for a small practice because of significantly lower complexity and lower cost than a participant-directed plan.
4) When practice owners start the process of adopting a plan later in the year, they might miss the October 1st deadline for a Safe Harbor plan. However, it may still be possible to get a plan and make a full contribution for the year via a design called QNEC (Qualified Non-Elective Contributions). This is something that large companies will not be doing, but small practice owners can benefit from this option if the plan providers are able to move quickly.
Konstantin Litovski
5) Adding a spouse to the payroll (and having them perform services for the practice) can be another way in which practice owners can increase their plan contributions. If done correctly, this is not only legal but a great way to save money on taxes.
6) Many small practices will want to add a Defined Benefit or a Cash Balance plan in addition to a 401k plan to maximize the owners’ contributions. These types of plans are very complex, so before adopting this plan, a thorough analysis needs to be done to select the best plan design.
Large plans have different issues and concerns than do the small practice plans, and these issues are often addressed differently. Small practices have a wide array of tools available at their disposal, but the added complexity will require a much higher quality and scope of advice than is necessary for larger plans.
Part 2, running tomorrow, will discuss investment management, explain essential services for small practice plans and also offer recommendations on the criteria that can be used by practice owners to select the best small practice plan providers.
What retirement plan do you offer for your small practice? A 401(k)? A SIMPLE IRA? What problems have you run in to with it? What do you wish you had done differently? Comment below!
Can you please elaborate on #5? What do you mean by adding a spouse correctly?
First, take a look here:
http://www.crossroadstax.com/blog/hiring-your-spouse-for-your-practice-make-sure-the-numbers-make-sense
Lots of good advice there from Chris. Basically, before ‘hiring’ a spouse you will need a written job description, and they do not have to be physically at the office, but you can’t just add a spouse on the payroll without having a job description.
Once the formalities are done, there is the question of compensation. Anything more than $25k or so does not make a lot of sense tax-wise. There is a ‘sweet spot’ between $20k-$25k that allows you to max out their 401k contribution while minimizing the payroll taxes you have to pay on their salary.
Of course, this comment was meant for a ‘stay at home’ spouse, not for your business partner spouse. In that case you’ll be partners/co-owners, and the salaries will be set differently.
When we set up our plan last year we got 3 different ideas from 3 companies. It was interesting to see how the plan evolved as I talked to one, then another and another company.
We ended up with the safe harbor/profit sharing and so far I’ve been happy. Although there have been some surprises along the way, like full vesting at 65 etc. Having a great TPA is key though as they will be the person you interact the most with. The others he mentioned are there in the beginning, but it’s the TPA that I have worked the most with to better the plan.
Exactly! Part two will have the rest, which will discuss the value of having a great TPA, which is very important, however, the TPA is only 1/2 of the equation. Having a great fiduciary adviser can save you time and significant expenses as well. Small practice plans don’t have the benefit of receiving fiduciary advice, and the TPA is not a fiduciary, so they won’t help you do a lot of things that need to be done to have a successful plan. All of this will be covered extensively in part 2.
Kon,
Looking forward to part 2! Do you have any examples with numbers coming up? This all makes a lot of sense, but without numbers on expenses, obligations to employees, and physician owner/spouse savings potential it’s hard to pin down how much value this can bring to you.
You might be thinking of something like this:
http://quantiamd.com/player/yewvnfqav?cid=1467
This should have some examples of plan design. I couldn’t add any to the article as that would have quadrupled its size (it was long enough for two separate posts already). There is literally tons of details, and some are specific to a particular practice and/or plan design. Maybe over time I will do a more comprehensive list of case studies.
With retirement plans, examples don’t really help you understand how a plan will work for your specific practice, so I highly suggest that you work with someone to evaluate your situation and to do a design study specifically for your practice demographics. This is really the only way to see how a plan will work for you. Once you have employees, things do change, so unlike solo 401k plan where you have full control over everything, small practice plans are all about finding the optimal solution given various constraints. A great engineering problem indeed, and that’s why big firms cut corners as they do not get paid enough (or have enough capacity) to solve this problem for each individual practice.
I love this post as I am starting my own Practice and want to benefit from as much tax deferral as possible . I too would like to see some real life numbers plugged in. Thanks for the timely post!
Thank you your comment! Please try the link above to my Quantia MD presentation. Here’s another one that might have more background information:
http://quantiamd.com/player/ygrmdgmtk?cid=1467
This becomes much more complicated depending on the set up of your business. An LLC seems ideal whereas an s-corp(PC) makes it difficult to reach the 52k. The savings on payroll taxes doesn’t offset the drawback of not being able to max retirement savings. Wish I could tell myself that 12 years ago. Defined benefit sounds great but i wonder if the costs of contributing to all employees and the complexities make just putting money in taxable accounts better?
Right! However, S-corp (or an LLC taxed as S-corp) is an ideal set up if you make over $300k or so in net profit. This way you can give yourself a salary that can range from $200k – $260k (which will depend on plan design) and this will allow you to max out your contribution.
But you have to give yourself the right salary – it can not be below the amount necessary to max out your plan because you only save ~4% on taxes vs. 40%+ on tax deduction (you don’t actually save 40%, but rather the difference between your tax brackets now vs. in retirement, but significantly more than 4%). The CPAs often look only a part of the whole picture, and this is why I always make sure that our clients have the right entity and the right salary (as I found that CPAs often do not know that the salary has to be set according to the needs of the retirement plan design).
https://www.whitecoatinvestor.com/starting-a-401kprofit-sharing-plan-for-a-small-practice-friday-qa-series/
I’m running into this dilemma now. I’m set up as an S-corp with a custom 401k (that I’m in the process of trying to get changed). Apparently, this year I’ll be able to contribute approx $39,000 to in order to decrease my tax burden in 2015. According to my CPA, any increase in salary will result in significant increase in the payroll taxes, and since the addt’l 401(k) contributions will only defer the tax vs. the addt’l payroll tax that will never be recovered, financially you are better off with the reduced salary for now.
I’m not too sure of this… I’d expect that after 30+ years of compounding/the rule of 72 and an expected decrease in tax bracket in retirement that it’d make sense to max out my 401k this year despite the increase in taxes.
Most docs are only getting out of Medicare tax-2.9%, maybe 3.8%, so I think I’d rather max out the 401(k)/profit-sharing plan than save a few Medicare bucks. I mean, if you declare an extra $100K in salary, you can put an extra $20K into 401(K) will only paying $2900 in Medicare taxes. I think that’s probably a win, but it depends on rates of return and time the money stays in the account.
Increase in salary is NOT going to significantly increase your payroll taxes past $120k. Any CPA knows that. The most you’ll pay is 2.9% + 0.9% in extra taxes beyond $120k, and the tax savings will more than offset this. Yes, you will defer taxes, but in retirement you will be taxed at a lower tax rate, so the differences is most likely going to be higher than 3.8% in payroll taxes. Also in retirement you can implement aggressive Roth conversion strategies (right inside your 401k plan), so this can also allow you to minimize taxes on relatively large retirement plan balances.
There are several different types of plan designs, and your CPA most likely has no idea about that, so you need to have the best design that will work for your practice going forward, which requires some planning and running the numbers.
This is what happens when you let CPAs be the primary retirement plan advisers. They don’t know or see the big picture, and their advice is often very limited (and short-sighted). A retirement plan is a great long term platform to build wealth and to manage wealth, and it has to be used properly and overseen by an adviser who knows what they are doing.
Thanks for your replies, Kon and WCI! Any suggestions of how to convince my CPA of this?
I always try to bring the CPA into the discussion. He may have reservations about the plan. It always helps to understand where he’s coming from, and without doing a comprehensive analysis of your plan (and talking with your CPA) it is not possible to know what your CPA has a problem with. Maybe he needs to see breakeven point analysis, or a good explanation of why this plan design is best for you. Most large TPAs do a bad job when it comes to small plan designs, so your plan design might be too expensive. CPAs are very conservative, and they often err on the side of caution.
Maybe you can pay for some continuing education for him. 🙂
I’ve been paying myself the minimum acceptable salary and taking the rest as distributions but now I want to maximize my retirement funding. Could I double my salary and cut my distributions or would that trigger an audit? Is there a way(without a time machine) to fix the problem?
No need to panic. You can adjust your salary for this year and going forward, and decrease the distribution. For this to happen you have to know the minimum salary you need to max out your plan. Your TPA should be able to tell you that. I would worry about a doctor/dentist paying themselves a (significantly) below-market salary and taking the rest as distribution – this will surely trigger an audit. An IRS recently won a case against a CPA who did just that, so giving yourself a higher salary is actually a good thing both for your retirement plan contribution and for decreasing probability of audit.
Great! Thanks! I had actually moved past panic to hopelessness. I’ll come up with a plan to increase my salary with my CPA. I set up a safe harbor 401k with profit sharing this year and then was disappointed I couldn’t take advantage of it. If I can fix the income issue and my wife stops working through the office it should work. My wife should also soon have her own solo 401k so she’ll be ok.
Your wife can’t have a solo 401k if you have a 401k for your practice that has employees. This would be a controlled group scenario. Exactly the kinds of things I discuss in part 2 that you have to watch out for, and that the TPA won’t help you with.
If your wife doesn’t own any of the practice, what is keeping her from owning a separate business and having her own individual 401(k)?
Yes, that’s an option for sure, but only if both businesses have no employees. I know this is convoluted, but if you have two separate businesses with employees each owned by a spouse, and both are totally unrelated, this creates controlled group issues.
Please remember: marriage can lead to common control!
The OP was discussing having his wife who works for the practice open a separate solo 401k plan, which is a no-no.
Got a reference for the fact that marriage alone can create a controlled group issue?
Attribution through marriage:
http://www.irs.gov/pub/irs-tege/epchd704.pdf
Look at the example on page 7-13 and on page 7-63
If you own 100% of a practice, your spouse also is deemed to own 100% of that practice. While each of you will still have a separate 415 limit, both plans (if you have two separate plans) have to be tested together because of a controlled group situation. So you can have a plan for your wife, but it will not be worth it as the testing will be very complex to make sure that both plans comply with the IRS rules.
This stuff is very complex. There are exceptions to this rule (as this manual mentions), and so if I’m not 100% sure, I’d consult an ERISA attorney and get his opinion in writing.
The example on 7-13 specifically states it is because one spouse is working in the other spouse’s practice. It doesn’t prove your assertion.
However, the table and example in 7-63 seems to. Really very unfair, isn’t it? A business you have nothing to do with other than being married to an owner affects how much you can contribute to your retirement plan. Another example of a marriage penalty in the tax code.
Yes! When I first heard of this, I thought it was completely nuts. I think they implemented these rules (and all of their intended and unintended consequences) in response to many small practice owners trying to avoid covering their employees, and the government (of course) wants all employers, without regard to size to provide for their employees if they open a retirement plan for themselves. So the effect of this is that if you have more than a certain number of employees, you can’t even afford having a retirement plan!
I’m seeing this in a practice where the ratio is more like 1:10 – then it really hurts the practice owners. Once the ratio falls below that and there are multiple partners, things get easier, but small practice that has an unfavorable owner to employee ratio will definitely get dinged by having to cover their employees (and by other ‘rules’ such as this one).
You’re not necessarily dinged, as long as you reduce their salary enough to make up for the retirement plan costs.
I am interested about that one also. Seems silly if I own an office with employees and my wife is an independent contractor who works for another group or two that she couldn’t have a plan. But, wouldn’t be the first time that the government surprised me.
But a clarification would be good, doesn’t apply to me yet, but always good to know for the future.
She can, but it will have to be tested together with your practice plan, making this arrangement impractical. It is not really an issue to include your wife in your plan.
Wow! Thanks for shooting down my master plan! I guess it’s better to find out about it now rather then by certified mail. Back to the drawing board. Seriously, thank you for the responses! This site is incredibly helpful! That could make a big difference in trying to decide if my wife should be a contractor or an employee.
Better shoot it down now than having to hire an attorney later 😉
Kon,
I am a veterinarian with 13 employees, one highly paid associate doctor. I have a SIMPLE IRA plan and have found it to be too expensive for me. My income has limited myself from using my own personal SIMPLE IRA , I make more than the $183,000 limit but I still must pay for my employees that participate. I will discontinue my plan and give my employees that participate a bonus check at year end to put into a ROTH. I do have an LLC with no employees but have that controlled group scenario.
Do I have any good options financially for a retirement plan for me ??
For one thing you can do a 2% match vs. giving 3% to everyone. Thus only those who WANT to participate will get the match vs. giving everybody 3%.
With a 401k you can exclude the associate and you can max out yourself. Also, with a 401k you can add a vesting schedule so that you can have your plan as a tool to retain employees (and keep the profit sharing contribution if the vesting conditions aren’t met).
It is worth doing a design study to see which option will work best for you – without having an exact census for your practice I won’t be able to tell you which option is best. It might come out that a SIMPLE with a 2% match is more cost effective, OR it might come out that a 401k with profit sharing is better for you.
Is your spouse working? If not, your spouse can potentially be added to the payroll (if done correctly) and this can increase your overall contribution into the plan.
The devil is always in the details.
Kon,
Yes the details have cost me a bunch of money !! Unfortunately now that I have money to put in retirement accounts and not the debt of my practice, I have income too high to put money in !!
Not a bad problem but poor financial planning . I will do a design study (finally) to see what works best. With a income over the limits for any tax deductible accounts, does it make sense to employ my wife ? She actually does work for me but with payroll taxes we figured there was really no need, we just take a draw.
You might be phased out for traditional IRA contribution deduction, but you can certainly contribute $53k into a 401k plan, and you can do a backdoor Roth contribution as well, for which there is no income limit.
We can do a design study for you and include a SIMPLE IRA in the analysis. It will most likely be a good idea to include your wife and we can certainly help you figure out the optimal salary both for yourself and your wife as part of the design study.
If you have any questions, please feel free to get in touch – my email is [email protected].
Not great ones unfortunately. It might be worth going over your options with a retirement plan guy (such as the author of this post) but you may find that paying for all those employees makes it not worth it for you and you’d rather invest in taxable. On the other hand, if you can get your employees to understand that the retirement is worth getting paid less for…then it’s all the same money to you.
I agree 100%. Most vets are pretty cheap and paying so much tax to the government is hard, I’d much rather have it go to my employees. My employees however, being a bit hand to mouth, need as much pay as possible. Also in Vet medicine, salaries are so much lower than on the human side. But even if I start a more expensive plan than a SIMPLE, like a 401K, won’t I be limited out from my own plan with a higher income? I also am a bit hesitant with the defined benefit plans due to the expense . As a single owner of an S Corp, I seem extremely limited in retirement options. Any other readers finding the same experience ?
WCI has a good point. Sometimes a plan can be just way too expensive for you, and we have developed a way to easily ‘measure’ this, so if we see that your plan is not worth it for you, we’ll let you know. Sometimes even a SIMPLE can be too expensive!
However, ‘expensive’ is a relative term. If your tax savings are significantly higher than the rise in expense, then the plan would be worth it. Your contribution into a 401k plan is limited to $53k ($59k with catch-up if over 50), and this contribution level can be attained with a salary that ranges from about $200k to $265k, so if you are an S-corp., the rest of the profits can be distributed.
In fact, you have the most options available to you. Again, with a DB plan, only after doing a design study can you know for sure whether the plan will be worth it for you. If you can contribute significant amounts, even with the extra expense, the plan might potentially work. Everything will depend on your age, salary, and of course your practice demographics. Other practice owners’ experience will not have much bearing on your situation because in some cases a plan works much better than in other cases, so without doing the analysis we’ll simply continue guessing.
I would not recommend having a DB plan until you are very comfortable with a 401k plan. Adding a DB plan to a 401k plan has the effect of making the combined plan a lot more cost effective because you can more than double your contribution, while the cost will increase by less than a factor of two in many cases.
I would have your plan run by a few different groups, including Konstantine. That’s what I did and found out it would be worth it. I had them all run a worst case scenario and then ran my own numbers to confirm the time value of money vs. doing a taxable account etc. WCI post here https://www.whitecoatinvestor.com/starting-a-401kprofit-sharing-plan-for-a-small-practice-friday-qa-series/ helped me a lot with my math.
Get a few quotes and have them give some plan options and decide from there. I needed hard numbers to look at to compare, so that’s why I had them give examples. It took a lot of back and forth, but I’m happy so far, a couple years into it.
That was for William.
Kon,
Great article. I have a small dental practice and am in the process of implementing a 401k safe harbor with profit sharing. When you are setting up these type of plans, is there a certain percentage that you like to see being contributed to the principles of the plan verse the remaining employees? I would guess that it is more complex than a simple answer, but I didn’t know if their were general guidelines you went by. Thank you.
It all depends on your practice demographics. I never trust the big recordkeepers to do this right – we see time and time again how badly an average recordkeeper’s designs are. This is where doing many iterations and understanding potential future demographic changes is key. For a small practice things will change, for sure, depending on your demographics. So it does help to get several different quotes, and you should NEVER sign up with a provider until they do a design study for you so that you know exactly (not approximately) what your employer contribution would be. You also don’t want any future surprises – often these providers only include eligible employees, and they don’t show you what happens when everyone becomes eligible. This can also come as a surprise, especially if this is an older and/or higher compensated employee.
I have question regarding the individual 401 i had for my S corp.
I closed the S corp in 2014.
I transferred all the money in the plan to my current employer’s 401k
However i did not file the form 5500 EZ with the IRS (i did not know about this requirement). The plan assets were less than $250k.
The individual 401k now has a zero balance.
Now i am finding out that the form 5500 EZ has to be filed within 7 months of transferring all the assets.
I am beyond that deadline.
I read on the internet about the IRS penalty waiver program
Has anyone been in a similar situation?
Is this something i should handle myself or pay a CPA to file the forms?
how much would a CPA charge for filing this form?
any help would be greatly appreciated
Thanks
Yes, you should have filed, that’s for sure. I doubt a typical CPA would know what to do though – you are better of hiring an experienced TPA to handle this.