How can I tell if it will be beneficial to start a 401K/Profit-Sharing Plan for my solo practice?  I have several employees.  At what point am I better off investing in a taxable account instead of starting a 401K/Profit-Sharing Plan?


I've been thinking about this question for months.  It is an exceptional question, without a definite right answer.  401K/Profit-Sharing Plans have both costs and benefits, especially for the company owner.  You have to weigh the costs against the benefits to determine what the right choice is.  Remember that a 401K/Profit-Sharing Plan is a hybrid plan.  It has a 401K component, which allows for employees to voluntarily defer as much as 100% of their salary up to $17,500 (plus a $5,500 “catch-up” contribution if over 50) into a tax-deferred or Roth account.  It also has a Profit-Sharing Plan component, which allows for the employer to make additional contributions, up to the 2014 IRC limit of $52,000 ($57,500 if over 50).  Both of these types of plans are subject to different non-discrimination tests, which ensures that the employees of the business share with the owner in the benefits of the plan.

401K/Profit-Sharing Plan Benefits

1. You get the personal benefits of a 401K/Profit-Sharing Plan

  • Additional asset protection
  • Easier estate planning (just have to name beneficiaries)
  • Tax-protected growth
  • Tax rate arbitrage between contribution and withdrawal

2. You get to offer these same benefits to employees

  • Improve employee retention
  • Help provide for employees' retirement
  • Attract better employees

401K/Profit-Sharing Plan Costs and Downsides

  1. Implementation fees
  2. Ongoing management fees
  3. Possibly higher investment fees
  4. Money for 401K employee match/Safe Harbor contributions
  5. Money for Profit Sharing Plan contributions
  6. Employees may not value the 401K benefit as much as it costs you (they'd rather have a higher salary)
  7. Limited contributions ($52K at best, may be less if the owner does not make enough or if he chooses not to provide sufficient funds for contributions for his employees)

Taxable Account Benefits

  1. More investment options
  2. No implementation and management expenses (although these are paid pre-tax in a 401K/Profit-Sharing Plan)
  3. Minimal investment expenses
  4. No employee-related expenses
  5. Minimal compliance hassle

Taxable Account Downsides

  1. Higher taxes
  2. No asset protection
  3. Trickier estate planning
  4. No retirement plan for employees

Quantifying these factors

The difficulty ensues when you begin to try to quantify each of these factors.  How much is the additional asset protection worth to you?  That depends on your state, the amount of insurance you carry, your personal risk profile, your level of assets, and your own personal fear of litigation.  The estate planning benefit can be quantified as the expense and hassle of using a will and trust to determine where your assets go at death, instead of just naming beneficiaries as you would in a 401K/Profit-Sharing Plan.

The expenses of the 401K/Profit Sharing Plan are relatively easy to figure out by bringing in an experienced advisor who can give you a quote for the 401K initial and ongoing expenses.  If he is really good, he can keep your investment expenses no higher than they would be in a taxable account by using low-cost, passive funds in the plan. Employee Fiduciary, perhaps the lowest cost provider of 401Ks, would charge $500 for implementation of a 401K and $1,500 plus $0.08% of AUM for a small 401K.  There are some additional fees required for some required actuarial testing for a profit-sharing plan.  FPL and Litovsky Asset Management, two of my advertisers, also offer these services at a similar price.  Konstantin Litovsky pointed out to me in an email that the fees for running the plan are actually a minor expense.  The main expense associated with these plans is the contributions the owner would have to make for his employees.  The fewer the employees, the younger the employees, the lower paid the employees, and the higher the employee turnover, the less this cost will be, but it can be highly variable depending on plan design and the design of your business or practice.  We'll discuss more about this cost below, but plan on $2-5K per year in expenses for running the plan.

The personal tax benefits of the plan are relatively easy to calculate, although some guess work is required.  The tax-protected growth factor is simply the difference between investing in a taxable account vs investing in a Roth IRA.  The tax rate arbitrage, of course, depends on future, unknowable tax rates.  But if you're making contributions at a marginal rate of 33%, and withdrawing the money at an effective rate of 18%, the benefit of this arbitrage can easily exceed the benefit of the tax-protected growth.

The value to the employees is perhaps the most difficult number to quantify.  Each employee is different.  The less they save, the less they're paid, and the less they think about retirement, the lower this benefit will be.  It is quite possible that your expenses will be higher than the value your employees see in the benefit.

401K Top-Heavy/Non-Discrimination Testing

A 401K plan is generally considered top-heavy if at the end of the year more than 60% of the plan assets belong to “key employees” (i.e. the doc.)  If the plan is top-heavy, then you must meet two requirements.  The first is that you must meet “minimum contribution requirements” for the non-key employees.  This minimum contribution is the 3% of the employee's contribution.  So if you're paying a nurse $75K, a manager $75K, and receptionist $40K, and a tech $40K, and none of them contribute to the plan, then you'll need to make a total contribution of $230K*3% = $6900 if you wish to max out your own benefit.  You may also match employee contributions dollar for dollar up to 4% of their salary.  If your goal is to maximize your personal benefit from the plan (and thus minimize the contributions you make for employees), then you would favor the 4% rule if your employees don't contribute much, and the 3% rule if your employees use the plan heavily.

The second top-heavy requirement for a 401K plan is a vesting requirement.  Employee contributions are always 100% vested, but the employer contributions (whether a simple 3% of their salary or a 4% match) must be either 100% vested after 3 years, or 20% vested after 2 years, with 20% vesting for each additional year (100% vested at 6 years).  If you do not meet both of these requirements, your plan may no longer be “qualified”, meaning you will lose the tax breaks the IRS provides for 401Ks.

“Safe Harbor” 401Ks are those that make a minimum “safe harbor” contribution or each employee.  The safe harbor contribution is either 3% of pay or a 4% match, but it must be vested immediately.  Since any plan including a physician and her employees is almost surely going to be top-heavy, plan on making Safe Harbor contributions each year when running your numbers.

Profit-Sharing Plan Top-Heavy/Non-Discrimination Testing

If you thought that was complicated, you haven't seen anything yet.  I think most physicians are capable of managing their own investment portfolio.  However, I do not think most of them are capable of designing the retirement plan for their practice.  The assistance of a professional (with an actuary on staff) is invaluable in this process.

There are “safe harbor” provisions for profit-sharing plans, however, they generally result in the highest required payments for your employees.  The more complicated, non-safe harbor, methods of determining the match are mostly likely to minimize this expense.  There are at least 6 methods for making sure your plan doesn't discriminate against your non-highly compensated employees.

Design-based Safe Harbor (Uniform Allocation) Methods

  1. Uniform Percentage of Pay Method (also called Salary Ratio)
  2. Uniform Dollar Amount Method (not common for small businesses)
  3. Integration Method

Non-design-based Safe Harbor Method

4.  Uniform Points Method (not common for small businesses)

Non-Safe Harbor Methods

5.  Age-Weighted Method

6.  New Comparability Method

The Uniform Percentage of Pay Method is the easiest to understand.  If you want to “profit-share” the maximum 20% of the owner's salary, you'll need to do the same for all of the employees.  So if your nurse makes $60,000, you'll need to make a profit-sharing contribution of $12,000.  If you have a couple of other employees making $30,000, your profit-sharing component could represent a cost of $24,000 per year!  You can see why a practice owner with multiple employees might simply choose to invest in a taxable account instead of using a Profit-Sharing Plan.  If your employees really value this benefit (and thus you can reduce the offered salary as a result of it), then this may be a great way to go.  It is certainly straightforward.

The Integration Method is a little more complicated.  Basically, this method allows you to profit-share a little lower percentage of your employees pay.  So you might be able to do 20% for yourself, but only have to do 16-18% for your employees.  It basically takes into account the fact that Social Security is progressive.  The math is a little bit complicated.  You're probably not going to want to do it without a professional's help.

The Age-Weighted Method is a great way to go if the business/practice owner is much older than all the employees. The logic behind this method is that contributions need to be comparable AT RETIREMENT AGE.  So if you're 60, the retirement age in the plan is 65, and the employees are 25, then a small lump sum at 25 that is allowed to grow for 40 years is equal to a much larger lump sum at 60 that can only grow for 5 years, especially when discounted at the maximum allowed 8.5%.  A really young employee may only get a profit-sharing contribution of 3 or 4% of salary where the older owner can get a 20% contribution.  Beware, however, of hiring older staff with this method, even if they are not paid well.  The profit-sharing contribution could be much higher than 20%!

The New Comparability Method is gaining more popularity all the time among those who wish to minimize the size of the required contributions for employees.  With this one, you split employees into different groups, such as Doctors/Owners and All Other Employees.  It turns out you can profit-share just 5% of salary with the “All Other Employees” group, while profit-sharing 20% of your own salary.  Obviously this is going to save a whole lot of cash compared to the Uniform Percentage of Pay Method, since it cuts your required profit-sharing contributions by 75%.

401K Vs Taxable Account

So, let's compare just using a standard 401K against a Taxable account.  Let's assume you have 4 employees whose combined salaries are $230,000 and you're going to use the 3% Safe Harbor mandatory contribution.  If you use Employee Fiduciary, your costs are going to be less than $2,000.  Your employer contributions are going to run 3% * $230K = $6900, for a total of $8900 per year (pre-tax, of course.)  In return for spending this money, you get to tax-defer $17,500 per year.  Let's assume you do this for 30 years.  Let's also assume your current marginal tax rate is 33%, that you can withdraw your 401K contributions in retirement at an effective rate of 17%, that your investments gain 8% per year pre-tax, that you use the same investments both within and without a 401K, and that you invest in a taxable account in a very tax-efficient way but still have a 20% dividend/long-term capital gains rate.  We'll ignore the value of the asset protection, estate planning, and employee relationship benefits in this analysis, all of which, of course, favor the 401K.

The benefits of tax-free growth on the $17.5K*0.67 = $11,725 are equal to $301,401, the difference between what $11,725 would grow to in a Roth IRA at 8% per year ($1,434,505) and what it would grow to in a taxable account at a pre-tax 8% ($1,133,104).  This is the equivalent of a return that is 1.26% per year lower.

The benefit of the tax rate arbitrage (contribute at 33% marginal rate, withdraw at 17% effective rate) would add another $342,569, or about 1.10% per year higher.

So the total benefit of the 401K over just using a taxable account after 30 years (this, of course, ignores the benefit of further tax-deferred growth during retirement) is $643,970.

What is the total cost?  For this particular doctor, it is $8,900 per year pre-tax, or $5,963.  In a taxable account over 30 years, that would grow to $576,264.  With a benefit of $67,706 plus the difficult to quantify benefits of additional asset protection, easier estate planning, continued tax-deferred growth in retirement, and employee relationship benefits, it would seem a no-brainer for this doctor to go with this low-cost 401K.  However, if he had more employees, higher paid employees, a higher cost 401K, or a 401K with crappier investments, he could easily come out behind financially on this one.

Now let's repeat that exercise for a 401K/Profit-Sharing Plan for the same practice. The doctor now gets to put in $52,000 — $17,500 as a employee contribution and $34,500 as a profit-sharing contribution.  We'll assume that $34,500 is 20% of his pay and that he uses a New Comparability plan where the employees get a 5% profit-share.  Let's assume annual costs for the plan of $5000.  He will also need to contribute 3% + 5% of all the employee salaries ($18,400) for a total of $23,400 as a pre-tax business expense.

The benefit of the tax-deferral on the $52,000*.67 = $34,840 is $895,592.  The benefit of the tax-rate arbitrage is $954,298 for a total benefit of the 401K/Profit-Sharing Plan of $1,849,890.  The cost of the plan ($23,400 pre-tax growing in a taxable account at 8%) comes out to $1,515,122.  This doctor would come out $334,767 ahead, not including all the other benefits of the 401K/Profit-Sharing Plan.

Wrapping It All Up

Every practice and physician will need to run these numbers prior to implementing a 401K/Profit-Sharing Plan, but as long as you don't have too many highly paid employees and you stick to low cost retirement plan providers, most doctors will at least be able to break even financially while reaping the additional tax-protection, estate planning, and employee retention benefits.

What do you think?  Have you implemented a retirement plan for your employees?  Why or why not?  What type did you choose and why?  Comment below!