Turn the retirement plan into a transition vehicle

December 10, 2019 News

by Bruce Bryen, CPA, CVA

The opportune time to adopt sophisticated retirement plans for tax savings and as an option for the transition of the dental practice:

Based on consistently reporting high earnings at the dental practice, it is always the opportune time to adopt a sophisticated employer sponsored qualified retirement plan.  At the end of the dental practice’s fiscal year, the format of the IRS approved deferred compensation plan couldn’t be more appropriate for the current year’s timing of the tax deduction.  Since the more involved types of retirement plans such as the defined benefit plan defer huge amounts of income and taxes, a last minute adoption allows the entire current year’s allocation to be deferred almost indefinitely.  Based upon the owners and key employees ages, past income amounts and estimates for the future, sums of $150,000 or more can be deferred annually.  If the goals of the participants want that much to be placed in the accounts for them, it can be done.    

What are some of the details?

Of course with anything good, come the details of implementation.  The dental CPA with a background working with dental practices as well as with high income dentists is one of the most important advisors that the dentist can retain for this purpose.   Understanding the usual retirement plans is not enough.  The difference between the 401k, any defined contribution plan and a defined benefit plan could be hundreds of thousands of dollars in only a short time.  Learning on the job is very expensive for the dentist who wants to engage his or her regular CPA who may not be a dental CPA.  Someone with experience in these matters is needed. Even though that person’s price may seem high, especially the first year or two, there is a leveling off period and the fees become pretty reasonable for what you get.  When you count the current tax benefit and the amount of earnings and taxes that are tax deferred, a million dollars in about 6 years is a reasonable goal of achievement for the dentist. 

How do I get there?   

Let’s find out if an employer sponsored qualified defined benefit plan is the correct one for you.  Are you approaching fifty or older?  Do you have fairly consistent earnings that are typically on the high side?  Do you have a staff that is on average on the younger side or are you employing a large number of one specialty, such as hygienists? If you can answer yes to any of these questions, the defined benefit plan may be right for you.  Of course it is important to confer with your dental CPA before proceeding with anything of this nature.  The consistent earnings of a higher nature are important because unlike a defined contribution plan where there is a statutory maximum allowed as a deductible contribution, the defined benefit plan is based on a formula.

Here’s how it works:

The employer sponsored qualified defined benefit plan allows a reasonable design to be submitted for approval of its format.  Working with the dental CPA and a qualified actuary with an understanding of what the dental CPA has discussed regarding the goals of the owner, a plan can be arranged whereby the owner reports his or her compensation and then receives a deductible contribution based on the current and past compensation.  If the formula calls for the highly compensated employees, such as the owner, to receive 100% of compensation in retirement, that can be adopted as the approved formula.  Of course there can be no discrimination in the plan.  That means that all employees must receive “similar,” benefits based on their compensation, length of service at the dental practice, age and other criteria.  That information will be addressed by the dental CPA and actuary when designing the formula for retirement plan benefits. 

Looking at a specific hypothetical example:

An example can be the dentist who was reporting $300,000 in wages and paying federal and state taxes on those wages.  This scenario may now equate to reporting $150,000 in wages and the requirement of contributing $150,000 to the defined benefit plan as a deductible contribution on his or her behalf.  This saves the federal, state and medicare taxes for the current year and each succeeding year on the $150,000 previously reported as wages that was included as part of the $300,000.   At an assumed 50% tax rate including the double medicare tax as the owner, federal and state taxes and the extra medicare tax on the amount of earnings in excess of $250,000 for a married filing joint return, there is at least $75,000 per year not being paid in tax.  That means that about ½ of the expected $150,000 retirement plan contribution is being paid with the tax savings.  One can interpolate based on whatever salary or earned income, such as LLP, LLC or sole proprietorship “flow through,” earnings are reported.  “S” corporation income that is classified as a dividend or is reported as profit and not as salary does not count as earned income. The funding balance can be attained though various methodologies, especially if there is any type of personal savings accumulated.  This is another area to be discussed with the dental CPA.  Just like almost all qualified employer sponsored retirement plans, the defined benefit plan is immune from creditors and the earnings grow without tax until the funds are disbursed. 

Is there any downside to the implementation of the defined benefit plan?

There is a downside if it is thought of in that regard.  The defined benefit plan is dependent upon the sponsor’s (the dental practice) on time contribution.  Its earnings percentage in excess of the guarantee that is part of the original plan design reduces the succeeding contributions.  Its losses are added to the future contributions so that the plan guarantee of its earnings percentage is always met. In the event of a loss, the addition to the next year’s guarantee almost negates the cost as long as the earnings of the dental practice are consistent. Effectively, the government is assisting in paying for the losses that must be overcome by the plan sponsor.  Suppose there is a loss of $50,000 based on the stock market.  It that amount was added to future contributions and if the dentist is still in an approximate 50% tax bracket, doesn’t the government take on $25,000, or half of the additional contribution based on the dentist’s tax savings in paying for the previous loss. The losses are not contributed in the following year but that is another matter to discuss with the dental CPA so that it is understood how the payment of the losses is affordable. 

Start planning for the current and future year’s tax savings and an affordable exit strategy. 

Any time is the right time to adopt the employer sponsored qualified defined benefit plan for current tax savings.  Using the same format in the adoption of the plan, think how a hypothetical buyer and the dental practice owner can defer the taxes on the transition of the practice.  Discuss with the dental CPA how the net effective tax cost to the potential buyer is drastically minimized and the seller’s tax is deferred for almost as many years as is desired.  Does the idea of a $500,000 sale today subject to taxes being deferred into a $500,000 sale with minimal to no taxes today sound like a good concept?  Also, when the funds are ready for distribution after the transition and after an accumulation in the retirement plan, how much will be there?  Will it be $750,000 or more?  Won’t the taxes to be paid upon the distributions come from money that would not have been there except for the adoption of the retirement plan?