When it comes down to types of retirement plans, let’s start with the two broadest categories: Defined Benefit Plans and Defined Contribution Plans. Although the basic concept—to provide retirement income—is the same for both broad types, how they get there is completely different. Understanding the difference will help you decide which is a better fit for you and your medical practice.
A Defined Benefit Plan, at one time called a traditional pension plan, promises an employee a monthly benefit at retirement for life. The maximum benefit to be provided to an employee is the lesser of 100% of pay or $185,000 a year. In a Defined Contribution Plan, the limit is not on the benefit but on the contribution itself. For 2008, that limit cannot exceed $46,000 per year.
So one type of plan limits the amount of benefit and the other limits the maximum contribution. How do you determine which one is better for your practice? This week we’ll look at the Defined Benefit Model and we will analyze Defined Contribution Plans in an upcoming blog.
There are several significant benefits to using a Defined Benefit (DB) Plan, especially if you have large profits and are relatively close to retirement. Since the rules require that you fund for a benefit for life, it is important to note that the closer you are to retirement and the larger the benefit, the greater the required contribution.
Let us start with how much money you would need in a plan to provide an employee with a pension of $ 185,000 a year. Using actuarial tables (these calculations are done by a professional driver on a closed course—please do not try them at home!), we can establish that the lump sum needed to provide for a maximum pension is about $2.2 million.
That’s a fairly nice sum. So how much do you have to contribute to fund a lump sum of $2.2 million? It depends on your age. Therefore the younger you are, the more time you have for your funds to grow and the smaller the contribution. If you are age 55 and are looking to fund for an age 65 retirement, we would expect that you would have to deposit about $175,000 a year for 10 years. Quite a big deduction!
On the other hand, if you were age 35, this same benefit would be funded by a contribution of $33,000 a year less than what you would be allowed to deposit in a Defined Contribution plan. The benefit to the beneficiary would decline based on age. So first things first: in order for this plan to be beneficial, the prime beneficiary of the plan needs to be 45 or older.
So now we have seen the possible power that a DB plan would have for a profitable medical practice where the principal is over age 45. Obviously, this cannot come without some drawbacks. First, because these calculations are complicated, an extra form must be filed with the annual pension package (the 5500 series needs to be filed with all pension plans and a special Schedule B signed by an enrolled actuary is also required) so the annual filing fee is generally higher than a defined contribution plan.
There are some other drawbacks which we will cover next week.
Remember TINSTAAFL? I will send a free signed copy of my book, You Can Afford to Retire, to the first physician-visitor who figures out what that means and e-mails me.