We often talk to doctors and physicians who are searching for retirement structuring. But more often than not, they are interested first in reducing their tax liability. Retirement advice for doctors can be more challenging because doctors have unique tax and financial situations.
Retirement planning is not a one size fits all approach. If a doctor is simply an independent contractor or has just a few employees, then there are a couple of perfect structures. It will usually employ a 401k (with profit sharing) in addition to a defined benefit plan.
The majority of our doctor clients will quickly understand how 401k plans work. But a defined benefit plan is a different animal. Let’s take a look at how they work.
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Retirement Advice for Doctors: Defined Benefit Plans
Defined benefit plans (as well as other types of hybrid defined benefit plans like cash balance plans) are beginning to receive increased attention. Available literature indicates that transition appears to be largely aimed at making employers more attractive to workers who do not plan to remain with the same employer for their entire career.
A cash balance defined benefit plan promises these workers a larger benefit than they would receive under a traditional defined benefit pension plan, as well as a benefit accrual pattern that may be better understood. Cash balance and other hybrid plans contain features of both defined benefit (DB) and defined contribution (DC) plans. This allows the plan sponsor and participants to take advantage of features of both types of plans (see our dummies post).
One key reason for the growth of cash balance plans was the improved ease of understanding of a participant’s retirement benefit. Another reason was the movement to retirement income based on lump sum values, similar to 401(k) savings plans, and the availability of lump sum payment options.
More recently, small employers have adopted cash balance plans since defined benefit plans may provide higher retirement income than defined contribution plans. A cash balance pension plan is a defined benefit pension plan. Cash balance plans are career average plans in which benefits are accrued incrementally year by year.
Retirement Advice for Doctors: The Formula
The benefit is defined by a formula containing a specified pay credit (or allocation) which is placed into a hypothetical account for each participant. A cash balance plan mimics a money purchase pension plan formula; the employer contributes to each participant a percentage of their plan year compensation (as opposed to average annual compensation).
This allocation is called a “Hypothetical Allocation”. To determine a participant’s accrued benefit at any particular time, the hypothetical account balance is projected, with interest, to normal retirement age. This projected lump sum amount is then converted to an annuity by dividing the amount by the an annuity purchase rate specified under the plan.
Let’s examine some of the advantages of a defined benefit plan:
- In general, they allow for significantly higher employer contributions than other types of plans. This allows you to take a large tax deduction and funnel substantial funds into the plan. We can assist in the calculation.
- Significant benefits possible in a relatively short period of time.
- Can be combined with other retirement plans including a 401k.
- Can be a business of any size in any industry including solo practitioners.
- Vesting can be immediate or spread out over a seven-year period.
- Plan can be used to promote certain business strategies by offering subsidized early retirement benefits.
- Participant loans are allowed.
- No set contribution limits. The deduction limit is calculated by an actuary and is any amount up to the plan’s unfunded current liability.
- Benefits are not dependent on asset returns.
Quality retirement advice for doctors should encompass many factors. But the most important is considering a defined benefit plan. This is often the best strategy of all.