August 2001 Bulletin

How to analyze options to benefit you, your practice

When analyzing retirement plan options for you, your partners and your practice, there are certain fundamental goals to keep in mind. These are:

1. Contribute the maximum amount possible to the retirement plan at the lowest cost possible to the practice. This analysis evaluates the non-physician corporate/ practice contribution as a percent of non-physician employee’s compensation compared to the same ratio for the physicians.
2. Utilization of a vesting schedule that insures non-physician employees need to remain in the employment of the practice as long as possible before the retirement account vests 100 percent for the employee.
3. Preparation of a cost-benefit analysis that compares the amount contributed on each physician’s behalf (i.e., benefit) to the cost of contributing on behalf of staff. This amount is then compared to the net after tax additional compensation that would be paid to the physicians if there were no retirement plan for the practice. You would compare the long-term growth of the assets in the plan and the resulting value to the long-term growth of the after-tax amount invested from the additional compensation paid to the physician if a plan were not implemented.

To determine which formula will work for your practice, the practice needs to determine the cost of making this contribution on behalf of the employees. If no retirement plan contribution were made, it is then assumed that the physicians would take the employees’ contribution, as well as their own contribution out as additional compensation. Thus, the physicians would receive ($30,000 in 2000, $35,000 in 2001 and $40,000 in 2002) in additional compensation (their retirement plan contribution that would not therefore be placed in the plan) plus their proportionate share of the employee’s contributions that would not be made. This additional compensation would be subject to federal income tax, state income tax and Medicare tax.

Simplistically, we could assume the physician would be left with 55 percent of the total amount of compensation to invest. This after-tax amount may or may not be more than the $35,000, which otherwise would be contributed to the retirement plan on behalf of the physician. The second step in the analysis is to then compare the $35,000 contribution growing on a tax deferred basis over some period of time to retirement, and compare this projected account balance to investing the after-tax additional compensation in a taxable account. At the end of the 25-year period, if the retirement plan account balance exceeds the taxable account balance, then the practice should have a retirement plan.

Example:

If no contribution were made to the plan, we assume the physician would have an additional $55,000 in taxable compensation. If we assume the highest federal rate combined with Medicare taxes and state income taxes, we estimate a combined tax rate of 45 percent, thus the physicians take home is 55 percent or $30,250.

The analysis now considers having $35,000 invested every year in a tax-exempt trust for a 25-year period, compared with the physician investing $30,250 every year in a taxable account. At the end of the 25-year period, and assuming an average tax rate, which would be paid on the funds accumulated in the retirement account, we end up with an estimated after tax balance on the retirement funds accumulated compared with an estimated balance on the personal tax affected account balance.

Assumptions:

• Annual investment rate of return 8 percent
• $35,000 invested in the tax exempt retirement plan trust for 25 years
• $30,250 invested in the taxable account of the physician for 25 years
• 25 percent effective federal tax rate on the investment earnings of the personal account of the physician assuming a blend of the 20 percent capital gains tax rate, plus an ordinary income tax rate of 36 percent
• 30 percent average effective federal tax rate on the distributions made from the retirement plan account upon the physicians retirement

Under this analysis, it would be beneficial for the physician to implement a retirement plan.

The analysis has many variables and could change the decision based upon the variable utilized. This includes the current effective tax rate on the personal account earnings as well as the effective tax rate utilized on the retirement plan distributions upon retirement. We assume the same investment rate of return on both accounts, but the physician may argue a different rate on the personal account vs. the retirement account. Lastly, the retirement account will continue with tax-deferred growth, but these assumptions do not project beyond the 25-year period.

Some general rules of thumb would indicate the following:

• Practices made up of between one and four physicians may find that the benefits do not exceed the cost of having such a lucrative retirement plan. This may not be a decision not to have a plan, but may be a decision to not fund the plan to the maximum level available.
• Five physicians or more in a practice would generally indicate that it is more beneficial to implement a retirement plan with the full level of funding and that the benefits exceed the cost of such a retirement plan.
• Tax deferred investing, even with the myriad of retirement plan law changes over time, will typically place an individual in a better financial position when compared to the alternative of annually engaging in taxed disadvantaged investing (investments made outside of taxable trust).

Many physicians will find the need to analyze the most recent tax law retirement plan changes, and will likely find that they are not as beneficial as they first appear. Using the same type of cost benefit analysis, the physicians may determine that increasing the contribution for the highly paid physicians from $30,000 to $35,000 may cost more than this benefit when comparing the cost to contribute on behalf of employees.

Lastly, as compensation continues to decrease and physicians are continually stretched to meet their daily living needs, the retirement plan, while still a very good long-term benefit, may lose out to the short-term need to meet cash flow obligations.

With appropriate assistance, you can make an outstanding decision with respect to your financial future by going through the appropriate process in the analysis and selection of retirement plan options.