Broaden Your Retirement Savings Horizon

Physician's Money Digest, November15 2003, Volume 10, Issue 21

With the passage of theEconomic Growth andTax Reconciliation Act of2001, defined-benefit anddefined-contribution plans have becomemuch more appealing. Now, more thanany time since the early 1980s, a defined-benefitplan is the best way for olderphysicians to catch-up, accumulate themost money for retirement in the shortestperiod of time, and generate a significanttax deduction in the process.

Currently, the annual tax-deductiblecontribution allowed for a physician participatingin a defined-contribution planis about $40,000 annually. However,with a properly designed defined-benefitplan, a physician who wants to catch-upcan contribute a maximum tax-deductiblecontribution that is at least 50%of their compensation.

Savings Opportunity

At the end of 2002, Dr. Paul Goddardclosed his practice and rolled his 401(k)into an IRA. In early 2003, he signed a 6-year contract with a local health careclinic, contracting his services at anannual rate of $400,000. As such, he hasformed a Professional Association (PA),of which he is the sole owner andemployee. At age 63, he is looking for thelargest tax deduction he can obtain sothat he can aggressively put away moneyfor retirement. He anticipates retiringbetween ages 68 and 70.

To achieve his goal, Dr. Goddardshould consider a 412(i) defined-benefitpension plan. This type of plan promisesto pay a monthly retirement benefitto its participants when they turn normalretirement age (most retirementplans specify age 65 as the normal retirementage, although it can vary). Theplan sponsor, the employer (ie, Dr.Goddard's PA), is required to make significantannual contributions to a trustso that, along with investment performance,there is enough money to pay apromised benefit during retirement.

The 412(i) plan is a fully insureddefined-benefit plan that is exempt fromthe funding rules of IRC Section 412because of the guaranteed aspects of theannuity and/or life insurance contractsthat are required to fund the plan.Under the plan, a third party administratoruses guaranteed interest rates onthe annuity or insurance contract todetermine deductible contributions,which result in larger initial contributions.Following is a list of the IRS requirementsfor a 412(i) plan:

  • The plan must be funded exclusivelywith an annuity and/or life insurancecontract.
  • Contracts must fund the benefitsusing level contributions, which arepayable at the normal retirement agespecified by the plan.
  • Dividends as well as any excessinterest earned must be used to reducefuture contributions.
  • Plan benefits must be provided byannuity/insurance contracts and beguaranteed by an insurance company.
  • Participants may not take loans.
  • Contracts may not be assigned ascollateral while they are part of thequalified plan.
  • Contributions must be madebefore an employee's retirement planbenefits can commence.

Retirement Benefits

Employee Retirement Income SecurityAct regulations limit annual plan benefitsfor a qualified plan. This limit iscommonly referred to as the "415 limit."For defined-benefit plans, the currentlimit (2002 indexed for inflation) is thelesser of 100% of the participant's 3 high-est years of compensation, or $160,000of annual income. This maximum limitis reduced if the monthly benefit beginsbefore age 62. In addition, contributionsare usually higher for older participantsthan for younger, since older participantshave less time to save.

Assuming Dr. Goddard was to roll hismoney into an IRA at the end of his 68thyear after 5 years of contributions and along-term rate of return of 6%, he wouldthen be able to withdraw approximately$100,900 annually through age 90. Inother words, Dr. Goddard would be ableto make tax-deductible contributions of$1.2 million over 5 years, and withdraw$2.3 million over 23 years. Earnings accumulatetax-deferred; taxes are incurredupon contribution distribution.

Employee Sponsorship

All contributions to fund the plan arefully deductible to the employer. Employerswho sponsor the plan must offerparticipation to all full-time employees(1000 hours or more per year) who areage 21, US citizens, and are not coveredunder a retirement plan required under acollective bargaining agreement. If 2 ormore businesses have common ownershipthat makes them a "controlled group," orif a business has leased employees, all suchemployees of these businesses generallymust be covered under the plan.

The plan document will determinewaiting periods, vesting schedules, andbenefit accrual formulas. Should a planparticipant terminate employment priorto retirement, their vested accrued benefitcan be paid out in a single sum, or pensionbenefits can begin at the earliest retirementage provided by the plan and electedby the participant. As with any qualifiedretirement plan, distributions prior to age591/2 are subject to income taxes andpenalties. Distributions must commencebefore the participant turns age 70 1/2.

Ideal Plan Participants

Is a 412(i) defined-benefit plan idealfor you? The answer to this questiondepends on your current professionaland financial situation. However, tomaximize the benefits to the physician,this plan should only be adopted underthe following conditions:

  • Generally, the physician should beno younger than age 50, with an annualcompensation of at least $200,000.
  • The physician's practice should employno more than 5 employees, preferablylower paid, younger employees.
  • Practice income should be relativelystable, while allowing for someflexibility in the physician's compensation,if necessary.
  • The physician plan sponsor must bedisciplined and work within the fundingrequirements of the plan and the plan'sactuary to plot a course that meets thephysician's future retirement goals.
  • The physician should intend onfunding such a defined-benefit plan forno less than 5 years.

A 412(i) defined-benefit plan is notfor everyone. However, for those of youwho have not done a proper job fundingyour retirement; have at least a 5-year retirement time horizon; earn agood, stable income; retain only a fewyounger, lower paid employees; andneed to play catch-up with your retirementsavings, a 412(i) plan may be yourkey to a comfortable retirement. Seekthe advice of your financial advisor forfurther information.

Thomas R. Kosky and his partner,Harris L. Kerker, are principals ofthe Asset Planning Group, Inc, inMiami, Fla. The company specializesin investment, retirement, andestate planning. Mr. Kosky alsoteaches corporate finance in the Saturday Executiveand Health Care Executive MBA Programs at theUniversity of Miami in Coral Gables, Fla. They welcomequestions or comments at 800-953-5508, orvisit www.assetplanning.net.