Retirement Planning

As a practice-owning physician, one way to save on taxes is to implement a retirement plan. As a financial professional, I have given this advice hundreds of times to business-owning professionals.

However, if you’re not aware of it and don’t plan for it, there is a tax trap looming that can cost you, as a practice-owning physician, a lot of time, headaches, and money. 

Rx Wealth recently consulted on a physician practice’s retirement plan and ran into a major retirement plan issue many physician business owners overlook. In one specific case, a physician and their spouse each had separate businesses and were greater than 80% owners. Each business provided a 401(k) plan for their separate employees. Because the physician and their spouse had a minor child, their separate business ownership is attributed to the minor child, creating common ownership amongst the two businesses, known as a “controlled group.” Therefore, the separate 401(k) plans need to be treated as one plan for tax compliance testing. Moreover, the two plans we reviewed provided different benefit levels for employees, adding the potential for the plans to be disqualified for tax purposes.

Before getting too concerned, know Congress understood situations will exist where each spouse owns a distinctly separate, unrelated business. Congress thus designed rules to avoid your business being considered owned by your spouse and vice versa. If you meet an exception, your retirement plans will not be treated as one plan across the businesses. The exception exists when the following are true:

• Each spouse owns no actual ownership in the other’s business;
• Neither spouse is an employee, director, or participates in management;
• The company does not derive earnings from passive sources, such as royalties, rents, dividends, interest, or annuities; and
• No restrictions exist on either spouse’s ability to sell shares in their respective business that are favorable to the other spouse or minor child.

For example, If Dr. Smith owns a practice and Attorney Smith owns a law firm, and neither is involved in any way with the other’s practice, there is considered no controlled group; each retirement plan will be considered separate. However, if Dr. & Mrs. Smith live in a community property state, the spouses have a community property ownership in one another’s business. Thus, they have actual ownership, not attributed ownership. 

However, if you and your spouse have a minor child,  Congress failed to create an exception similar to a spousal exception for your minor child to be excluded as an owner of either you and your spouse’s business through family attribution. This is the retirement tax trap for the unwary.  When you have a minor child, a controlled group may be created unknowingly.

What is a Controlled Group?

Congress set forth rules to determine if businesses are part of the same group for the purposes of applying retirement plan rules. We tax people affectionately refer to these rules as the “controlled group rules.” (1)

A controlled group is created when two or more businesses connected through common ownership have the same five or fewer individuals that own at least 80% of the stock of the corporations. Family attribution applies, so stock owned by a parent, grandparent, child, or spouse is often deemed owned by another related person. For instance, stock you own in your business is also deemed to be owned by your minor child.

Under the controlled group rules, two or more employers related through common ownership are deemed a single employer for retirement plan testing purposes. These rules often require controlled group members to cover their employees with the same 401(k) plan in order to pass annual compliance testing. 

Why Evaluate Plans for a Controlled Group?

When evaluating retirement plans for tax compliance, a determination needs to be made if the two businesses are considered part of a controlled group. If a controlled group exists, the plans must be evaluated as one plan to ensure compliance with the tax law. 

Should a plan fail its compliance testing, the IRS may disqualify the plan. It is imperative to make an accurate controlled group determination and cover the proper employees with the proper benefits.

These rules exist to prevent physicians and business owners from splitting their business into two companies and enriching themselves with generous retirement plans while providing employees in a second business with either less generous or no retirement plan. 

Controlled group rules are generally straightforward. A 401(k) provider, along with your financial advisor and attorney, can assist in determining controlled group status. The issue arises typically inadvertently because of a failure to provide necessary information to the 401(k) provider about the two businesses. 

So, what happens if you inadvertently fall into this tax trap? Well, no worries. The IRS is not looking to disqualify plans for mistakes as long as they are remedied. The IRS  puts forth several avenues to fix mistakes.

A Path to Fixing Retirement Plan Non-Compliance

The IRS lays out two paths to fix a plan failure. 

First, an employer can adopt a corrective amendment up to 9.5 months following the close of the plan year in which the failure occurred in order to expand plan coverage retroactively. However, since new 401(k) plan participants cannot retroactively contribute, the business must make up the employee contributions and any employer contributions the business should have made for all plan participants.

Should the mistake not be discovered within 9.5 months, a second path is available. On this path, the employer must go through the IRS’s Voluntary Compliance Program. When a Voluntary Compliance Program correction is necessary, though, employer fines can apply.

Not correcting a failure can result in plan disqualification should an IRS audit uncover the issue.

What This Means For You

It can be costly not to understand the rules regarding controlled groups and retirement plans. While mistakes are fixable, ensure testing is done each year. Further, alert your 401(k) provider if your spouse owns a business. And if you are a little overwhelmed or think you may have an issue with a retirement plan, please reach out to us for a complimentary call.

(1) See Internal Revenue Code Section 1563.

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.

Have you considered that you might not be in the retirement plan that gives you the best benefit?  

As an independent contract physician, you need to think about and plan for your own retirement. Because of your time in medical school, you naturally got a later start at building wealth than other professionals.

Given the late start, physicians need to be aggressive in their savings. Through our years of experience working with doctors, Rx Wealth has learned that the “magic contribution number” for physicians is usually between 30% to 40% of their gross income. This will allow you to become accustomed to a lifestyle that lets you fund your retirement and build the wealth you are entitled to as a doctor. 

Although saving 30% to 40% of your income seems like a lot, your level of earning as a physician should still afford you to have the lifestyle you desire and deserve. And, adopting a proactive, goals-based approach to building wealth will allow you to pursue a happy, stress-free retirement.

Generally, your savings begins with retirement plan contributions, so let’s take a look at your options. The numbers below reflect IRS contribution limits for 2021, so if you’re reading this article at a later date keep in mind that the specific contribution limit amounts may have changed.  

The SIMPLE IRA

The SIMPLE (Savings Incentive Match Plan for Employees) IRA is an easy-to-operate individual retirement account where a self-employed doctor can invest their retirement savings.

A SIMPLE has the following benefits:

• Easy and inexpensive to set up and operate.
• Contributions are pre-taxed.
• The maximum contribution per year is $13,500, and $16,500 if you are over age 50.
• May work well for young doctors in early earning years who are limited in the amount they can contribute.
• No need for tax filings.
• Wide selection of investments.
• The plan provides a layer of asset protection.

However, the SIMPLE has the following disadvantages:

• Participating causes any “backdoor” Roth IRA contributions to be partially taxable.
• You can contribute less than other retirement plans.
• If you have employees, you must make contributions for them.

The SEP IRA

The SEP (Simplified Employee Plan) IRA offers the chance to save your retirement money simply. The SEP IRA will only ask for a pre-tax contribution from you.

The SEP IRA has the following benefits:

• Easy and inexpensive to set up and operate.
• Only the employer or you, as a self-employed individual, can make contributions.
• Contributions are limited to 25% of annual employee compensation or $58,000. When self-employed this is based on self-employed earnings; if you operate as an S Corp, it is based on the wages you pay yourself.
• You have control of your investments and generally have a wide selection.
• No annual tax filings are required.
• The plan provides a level of asset protection.

However, SEPs comes with the following disadvantages:

• Elective salary deferrals and catch-ups over age 50 are not permitted.
• It is considered an IRA; thus, participating will cause backdoor Roth IRA contributions to be partially taxable.
• You must make employee contributions if you have employees other than yourself.

401(k) & Solo 401(k) Retirement Plan

A 401(k) and a Solo 401(k) retirement plan are the same plan, with one exception. The Solo 401(k) is for only a single employee or self-employed doctor and is ideal for doctors who conduct their practice through a sole proprietorship, single-member LLC, or an S Corporation and serve as their practice’s only full-time employee. 

A Solo 401(k) has the following benefits:

• If you are under 50, your maximum annual contribution limit will be $58,000 — $19,500 as your elective contribution and $38,500 as an employer contribution. If you are over 50, your maximum annual contribution limit is $26,000 as an employee and $38,500 for the employer, totaling $64,500.
• Solo 401(k) plans are easy to open, and most custodians have standard documents you can use to set up the plan.
• Most custodians do all tax reporting for the plan.  
• Since this is a 401(k) plan and not considered an IRA, you can do a backdoor Roth IRA contribution.
• Provides the doctor a level of asset protection against creditors.

A Solo 401(k) has the following disadvantages:

• The plan may require annual tax filings, which will cost some additional money in tax preparation fees. Filing Form 5500 or a simpler version of Form 5500 starts when plan assets exceed $250,000. However, this disadvantage is more than offset by the higher pre-tax contribution limits versus other plans and the ability to do backdoor Roth IRA contributions.
• Most custodians do not allow post-tax or Roth contributions to their standard plan.  
• To make Roth or post-tax contributions, a custom plan needs to be created through a third-party administrator.
• Custom plans cost about $1,000 to establish and $1,000 to $2,000 annually to maintain. 

In the opinion of Rx Wealth, there is nothing better than the Solo 401(k) retirement plan for the self-employed doctor without employees,

Cash Balance Plan

Have you maxed out your current retirement plan, but still looking for ways to save more pre-tax money? A cash balance plan may be just what you are looking for.

A cash balance plan acts like an “old school” pension plan and defines the benefits you are going to receive when you reach retirement age.  

A cash balance plan comes with the following benefits:

• Allows for high annual contributions based on a doctor’s age. Depending on age, you may be able to contribute over $100,000 or more per year on a tax-deductible basis.  
• Ability to supercharge your retirement savings.
• Provides a level of asset protection.

However, a cash balance plan comes with the following disadvantages:

• It takes a lot of work to set up and administer annually, so there are set up fees and annual costs that run from $2,500 to $3,500.   
• An annual tax filing is required.
• If a physician has full-time employees, contributions are required for employees.
• It’s generally recommended that contributions be made for at least three tax years, and the plan is somewhat inflexible as to a required annual contribution.    

While this plan provides extraordinary benefits, it does come with some inflexibility and required annual contributions. If you have sufficient excess cash flow to commit over a 3-year period or longer, consider implementing this in addition to a Solo 401(K).  A combined 401(k) and cash balance plan will supercharge your retirement savings.

The SIMPLE IRA, SEP IRA, Solo 401(k), and cash balance plan are four retirement plans you need to consider in 2021 if you are becoming or are self-employed. And if you are already self-employed, you should make sure the plan you selected is giving you the best benefits.

If you feel you are not in the best retirement plan or are struggling to select which plan best suits you, please schedule a complimentary consultation with us.

 

Rx Wealth Advisors is a physician-focused financial advisory firm. Their primary focus is to help medical doctors maximize their earnings, keep more money in their pocket, and cultivate wealth so they can live the life they’ve earned and deserve. Rx Wealth can be reached at 412-227-9007, via email at croe@rxwealthadvisors.com, or on the web at rxwealthadvisors.com.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.