If you're an owner of a profitable physician group, have 15 or fewer years until retirement, and are looking to boost your retirement nest egg while saving on taxes, you may want to take a closer look at a "defined benefit" retirement plan.
A. What is a Defined Benefit Plan?
A defined benefit plan provides a fixed monthly benefit starting at retirement age, based on a formula that varies with each plan, and that considers the employee's years of service and compensation.
For example, a defined benefit plan formula might provide an annual benefit, starting at age 65 and payable over the employee's lifetime, equal to 2% of average annual pay (for the final three years before retirement) multiplied by total years of service. So, someone retiring with 30 years of service, and average annual pay of $200,000 would receive a lifetime benefit of $120,000 per year (2% x $200,000 x 30) starting at age 65. A defined benefit plan also may provide a lump sum payment that is the actuarial equivalent of the annual benefit.
A defined benefit plan differs from a "defined contribution" plan. (Defined contribution plans include 401(k) plans and profit sharing plans.) In a defined contribution plan, the employer (and often the employee) contributes a certain amount each year to an individual account that is invested. The amount available at retirement-rather than a guaranteed fixed monthly benefit -is simply the contributions plus their investment earnings.
Like a defined contribution plan, a defined benefit plan can only take into account a certain amount of each employee's pay in determining benefits. That limit, which is $225,000 in 2007, increases each year based on inflation.
Despite this limit, both defined benefit and defined contribution plans offer important tax advantages. Contributions made to either type of plan are deductible to the owner/employer up to certain limits, while benefits are not taxed to the participant until they are distributed. In addition, the assets of either type of plan are shielded from creditors.
As has been widely reported, defined benefit plans have declined in popularity over the last 10 to 15 years, with many large employers either freezing benefits, or terminating their plans altogether. However, despite this trend, a defined benefit plan may still be an attractive option for owners of small professional corporations, especially those owners who are age 50 or older and have a younger staff of employees.
The main advantage of a defined benefit plan is that it allows for much higher tax-deductible contributions than a defined contribution plan. Annual contributions to a defined contribution plan by any individual are capped at a dollar limit set by the tax law-$45,000 in 2007. On the other hand, the annual contribution to a defined benefit plan is not capped and depends on the amount that is necessary to fund the retirement benefits promised under the plan.
Contributions to defined benefit plans are spread from the date the plan is established until the expected retirement date. If this period is relatively short (for example, the owners have 15 or fewer years until retirement), then a large annual contribution would be needed to fund the benefit. In that case, the annual tax-deductible contribution could be well in excess of the defined contribution limit. In fact, it is not uncommon for contributions to exceed $100,000 per year per individual owner.
The tax law does limit the amount of annual benefits that an individual can receive from a defined benefit plan. However, that limit is generous-a person retiring in 2007 at age 65 can receive a benefit as high as $180,000 per year, and that limit will increase in future years.
Further, the maximum benefit available in a defined benefit plan is available even if the owner also maintains a defined contribution plan, as long as the contribution to the defined contribution plan is not too great.
Defined benefit plans do have certain drawbacks. Defined benefit plan administration is more expensive, primarily because the owner/ employer must use an actuary to calculate the annual contribution needed to fund benefits. Many defined benefit plan sponsors also must pay annual premiums to the Pension Benefit Guaranty Corporation (PBGC), a federal agency that insures defined benefit plans. In addition, many defined benefit plans are subject to very strict rules for terminating the plan.
However, "professional service employers," including corporations owned by physicians with fewer than 25 employees, are exempt from PBGC premiums and the plan termination rules.
Like defined contribution plans, defined benefit plans must cover most of the corporation's full-time employees. However, if the staff is mostly younger, the contributions required to fund staff benefits will be relatively inexpensive because of lower pay levels and the length of time until retirement age. Also, many defined benefit plans can use longer vesting schedules than defined contribution plans, which can reduce costs if there is high turnover among staff.
Perhaps most importantly, defined benefit plan sponsors must understand that defined benefit plan contributions can vary from year to year, depending on factors such as employee demographics, pay changes and investment performance. That means that a doctor group might be required to make a larger than expected contribution in a particular year, which event could negatively impact the owners' take home pay that year.
The bottom line is that, while the common wisdom is that defined benefit plans are currently out of favor, they may actually be an attractive alternative for some doctor groups.