Maximize Tax Savings with Retirement Plans

For the owner of a successful professional practice, a retirement plan can do much more than help save for retirement. Properly designed, it can also create one of the practice’s largest recurring tax deductions.

This opportunity can be especially attractive for dentists, physicians, attorneys and other highly compensated professionals who earn substantially more than their employees—particularly when the practice has relatively few, younger, lower paid employees.

The strategy is often built in three layers:

1. Safe harbor 401(k): Allows the owner to maximize 401(k) salary deferrals without the usual testing restrictions that can affect highly compensated employees.
2. New comparability profit sharing: Can direct a substantially larger employer contribution to the owner than to staff, subject to IRS nondiscrimination testing.
3. Cash balance plan: Can add another layer of potentially large deductible employer contributions, often taking annual retirement funding well into six figures.

For many practices, the first two layers are enough. For an owner with consistently high income who wants to save and deduct substantially more, adding a cash balance plan may be worth considering.

Start with a safe harbor 401(k)

A safe harbor 401(k) generally requires the practice to make a minimum employer contribution for eligible employees. One common design is a 3% nonelective contribution, meaning the practice contributes 3% of compensation whether or not the employee puts any of their own money into the 401(k). In return, the 401(k) avoids annual nondiscrimination testing—called ADP/ACP testing—that can otherwise restrict how much owners and other highly compensated employees are allowed to contribute when rank-and-file employees contribute at lower rates.

In plain English, the safe harbor gives the owner much more certainty that he or she can maximize the 401(k). 

For a high income practice owner, however, the bigger opportunity often comes from adding new comparability profit sharing.

Add new comparability profit sharing

A traditional pro-rata profit sharing design generally gives every participant the same percentage of compensation. New comparability profit sharing, on the other hand, allows the plan to divide participants into groups—the owner and the staff, for example—and provide different contribution percentages to those groups. 

This does not mean the owner can simply give himself or herself a large contribution and give employees nothing. The plan still has to satisfy IRS nondiscrimination rules. Still, subject to those rules and the required testing, the plan can often be structured so that a significantly higher percentage of the total contributions is allocated to the owner.

The rules can work particularly well when:

• the owner earns substantially more than the staff;
• the owner is older than most employees; and
• the practice has relatively few employees.

Those demographics are common in many established professional practices.

New comparability plans can use “cross testing,” which compares the projected retirement benefits produced by current contributions. Because a younger employee’s contribution has more years to grow before retirement, a smaller current contribution can sometimes provide a comparable projected benefit to a larger contribution made for an older owner. The IRS specifically recognizes this type of new comparability design, subject to minimum employee contribution and nondiscrimination requirements.

Example: dentist with two employees

Assume a 49-year-old dentist owns a practice and has compensation of at least $360,000. The practice has two younger employees earning $60,000 and $70,000. Assume the plan is designed and tested so that the employees receive employer contributions equal to 5% of compensation, while the dentist can receive enough profit sharing to reach the $72,000 defined contribution limit.

A simplified illustration could look like this:

The two employees receive $6,500 in combined employer contributions—5% of their $130,000 of compensation.

The dentist receives a $47,500 employer contribution in addition to the $24,500 401(k) deferral, reaching the $72,000 annual defined contribution limit. That can be an attractive tradeoff. The practice provides a meaningful retirement benefit to employees while directing a substantially larger contribution to the owner.

A 5% contribution is a common benchmark in new comparability designs because the cross testing rules contain a minimum allocation gateway based on 5% or, in some circumstances, one-third of the highest allocation rate. But 5% is not a guarantee that a particular plan will pass testing. The actual result depends on the ages, compensation and eligibility of everyone participating in the plan.

What does the tax benefit look like?

The tax benefit generally comes from two places. First, traditional 401(k) salary deferrals reduce the participant’s current taxable income; and second, employer retirement plan contributions are generally deductible by the business, subject to applicable limits.

Suppose the dentist in our example receives the full $72,000 of pre-tax retirement funding. If that entire amount effectively replaces income that otherwise would have been taxed at a 37% federal marginal rate, the simple gross federal income tax effect is:

$72,000 × 37% = $26,640

That does not mean every dentist who contributes $72,000 saves exactly $26,640 in taxes. The actual result depends on factors such as filing status, entity structure, the qualified business income deduction, state taxes and how the contribution is made. And the benefit is primarily tax deferral, not tax elimination. Traditional retirement plan money is generally taxed when it is eventually distributed. Even so, for a professional in peak earning years, moving income from a high-tax working year into retirement can be extremely valuable.

Want a much bigger deduction? Add a cash balance plan

For some owners, roughly $72,000 of annual retirement funding is plenty. Others—particularly successful practice owners in their 50s and 60s—may ask:

“What if I want to put away $150,000, $200,000 or more each year?”

That is where a cash balance plan can become attractive.

Unlike a 401(k) plan, a cash balance plan does not simply have one fixed annual contribution limit. Instead, an actuary determines the required or permissible funding based on the promised retirement benefit, the owner’s age and compensation, plan assets, interest assumptions, and other actuarial considerations.

A cash balance can support significantly larger deductible employer contributions than a 401(k) or profit sharing plan. This can work especially well for an older, highly paid owner because there are fewer years remaining to fund the targeted retirement benefit. However, it is also more complex to establish and administer and requires ongoing actuarial involvement.

Example: dentist with a 401(k) + cash balance plan

Return to the dentist receiving $72,000 through the 401(k) and profit sharing plan. Now assume an actuary determines that the practice can appropriately fund an additional $150,000 for the dentist under a cash balance plan.

Annual retirement funding for the owner could then look like: 

$72,000 401(k) and profit sharing + $150,000 cash balance plan = $222,000 of annual retirement funding

The $150,000 figure is illustrative, not a statutory limit. The actual cash balance contribution could be substantially higher or lower depending on the owner’s age, compensation, existing benefits and the actuarial design of the plan. Also, $222,000 of retirement funding should not automatically be read as $222,000 of current tax deductions.

When a business maintains both a 401(k)/profit sharing plan and a defined benefit plan covering the same employees, additional combined plan deduction rules can apply. The employee contributions and benefits required to make the combined plan pass nondiscrimination testing can also differ from the 5% employee example above. That is why a 401(k)/profit sharing/cash balance plan combination should be modeled as a package by the plan administrator, actuary and tax adviser.

Why this can work particularly well for professionals

Advisers sometimes refer to this arrangement as a DC/DB combo:

DC (Defined Contribution) — Safe harbor 401(k) + new comparability profit sharing

DB (Defined Benefit) — Cash balance plan

The defined contribution plan provides the first layer of tax-advantaged retirement savings. The cash balance plan then provides an additional layer after the owner has effectively exhausted the 401(k)/profit sharing opportunity. For the right high income owner, the result can be six-figure annual retirement funding with substantial current tax benefits.

Why practice demographics matter

These strategies tend to be most attractive when the owner is:

• highly compensated;
• older than most employees;
• working with a relatively small staff; and
• generating consistent practice profits.

Consider a 55-year-old owner with four employees in their 20s and 30s. The owner may earn several hundred thousand dollars per year while employee compensation is much lower. Because the owner is closer to retirement, the plan may be able to provide a much larger dollar benefit to the owner while still satisfying the rules requiring meaningful benefits for employees.

That does not mean employees can be excluded. Quite the opposite: employee costs are an essential part of the analysis. The question is whether the owner’s additional tax-deferred retirement funding is sufficiently valuable to justify the required contributions for employees and administrative expense.

Often, it is. Sometimes, it is not.

That is why the practice census—the ages and compensation of every eligible employee—is so important.

What if the practice has no employees?

The analysis can be simpler for an owner with no common law employees other than, potentially, a spouse. An owner only or solo 401(k) can provide substantial retirement funding without the employee nondiscrimination issues that apply to a staffed practice. A cash balance plan can potentially be added as well.

For a highly compensated owner only professional practice, this combination may provide particularly large retirement contributions relative to the administrative cost.

The trade off: cash balance plans require commitment

A 401(k) with discretionary profit sharing generally provides considerable flexibility from year to year.

A cash balance plan requires more commitment.

Because it is a defined benefit pension plan, funding is actuarially determined and the employer has greater ongoing funding obligations. The IRS notes that defined benefit plans are more complex and more costly to maintain, and minimum funding requirements apply. Cash balance plans therefore tend to fit best when an owner has:

• consistently strong cash flow;
• several years of high income ahead;
• a desire to save substantially more than the 401(k) limits allow; and
• enough predictable profitability to comfortably make ongoing contributions.

A practice with highly variable profits may prefer the greater flexibility of a 401(k) and profit sharing plan alone.

A practical way to think about it

For a successful professional practice owner, the progression is often straightforward:

Step 1: Maximize the owner’s 401(k) salary deferral.

Step 2: Use a safe harbor design to provide certainty around the owner’s 401(k) contribution.

Step 3: Add new comparability profit sharing to increase the owner’s employer contribution while satisfying the rules for employees.

Step 4: If the owner still wants to put away substantially more, model a cash balance plan alongside the 401(k).

The important word is model. Two practices with identical profits can get very different results simply because their employee demographics are different. Before establishing a plan, a retirement plan administrator can run the employee census through several designs and show the owner the projected contribution for themselves, the required employee cost and the resulting tax considerations.

The bottom line

For a high income professional practice owner, retirement plan design should be viewed as part of the practice’s overall tax strategy—not simply as an employee benefit.

A safe harbor 401(k) combined with new comparability profit sharing can potentially allow an owner to reach the annual defined contribution maximum while keeping required employee contributions economically reasonable.

For an owner who wants to save substantially more, adding a cash balance plan may move annual retirement funding well into six figures.

For the right practice, the strategy can accomplish three things at once:

1. Build substantial personal retirement wealth;
2. Reduce current taxable income; and
3. Provide a valuable benefit to employees.

The opportunity depends heavily on the owner’s age and compensation, employee demographics, entity structure, practice profitability and the specific plan design. The numbers should therefore be modeled by a qualified retirement plan administrator and, when a cash balance plan is involved, an actuary, with the tax consequences reviewed by the owner’s tax adviser.

Contact us and we can help coordinate the modeling process so you can see the potential owner contribution, employee cost and tax benefit before deciding whether the strategy makes sense for your practice.

This article provides a general conceptual overview and is not tax, legal, actuarial or investment advice. Retirement plan rules and contribution limits change over time, and individual circumstances can materially affect the result.