7 Retirement Plan Essentials for Therapists
Retirement Plans. They are confusing.
And as a private practitioner, you’re a small business owner. And because you’re a business owner, you have a wide array of retirement plans available to choose from.
That’s great because you have a lot of flexibility (much more so than the typical retirement investor!)
But that’s bad because the choices are overwhelming and confusing.
This post is here to help!
I’ll break down the seven basics every therapists should understand about retirement plans BEOFRE jumping in and deciding what retirement plan is for you!
This is like Retirement Plans 101. So let’s take the 101 course, before we dive in 500-level course content.
1. The key question is how much you want to contribute.
You have a bewildering array of retirement plans you can choose from: IRAs, SEP-IRAs, SIMPLE IRA’s, & 401(k)’s to name a few.
It understandably can feel overwhelming and confusing.
But just remember the first question is answer is how much do you want to be contributing toward your retirement account each year? That amount will help you decide among the many different choices.
The more complex the retirement plan, the greater amount you can contribute each year.
IRAs are pretty simple to set up and maintain. They also have the lowest annual contribution limit.
401(k)’s are among the most complex plans to set up and maintain. They also offers some of the highest annual contribution limits.
So look at how much you want to save each year and then figure out which plan you need to reach that goal. There are other factors to consider, but this factor will usually should be the primary driver of your decision.
Start with your overall financial plan in mind, and the right retirement plan choice more naturally reveals itself.
2. Retirement Plans are containers — NOT investments!
One of the most important things to remember about all retirement plans is that they are NOT an investment. Retirement Plans are simply a type of account, just like a bank account.
In other words, a retirement plan is a container for your investments, but not the investment itself.
In fact, retirement plans can ‘contain’ virtually any type of investment you want. There are certain restrictions, but you don’t have to really worry about them. Why? Because a prudent investment strategy uses highly diversified, passively managed and low-cost investment funds. And those are just fine to have in any retirement plan you select.
When you open your retirement plan, you’ll need to pick an investment fund. If you're not certain what fund is right, I often recommend Vanguard Target Date Retirement Funds. Using these funds is as simple as retirement investment gets, and while this won’t be the perfect fund for everyone, it often is a very good choice. You simply pick the fund with the year closest to your expected retirement year and the fund takes care of the rest. Other firms besides Vanguard offer these target date funds, but I’ve found many of them have outrageous expense ratios.
3. Know the difference between retirement plans & retirement accounts.
I make a distinction between retirement PLANS and retirement ACCOUNTS.
Retirement plans must be “sponsored” by an employer. Your private practice is an employer eligible to sponsor a retirement plan. These retirement plans typically allow higher annual contributions than individual retirement accounts (which are NOT sponsored by an employer).
There are many different types of retirement plans and all use some type of retirement account for each individual participant of the plan. Each account within the plan is governed by the rules of the written plan - because it’s just that: a PLAN for how the whole thing operates.
In contrast to retirement plans, retirement accounts that are not attached to any employer-sponsored plan are simply Individual Retirement Arrangements (IRA’s). They are literally an individual arrangement instead of an employer plan.This “ordinary” IRA is not sponsored by an employer - it’s opened and maintained by an individual.
Pretty much anyone with earnings from employment can open and fund an IRA. Again, it doesn’t need to be linked to (e.g. sponsored by) an employer. In fact, IRAs were created for just this purpose: to offer employees whose employers don’t offer a retirement plan a way to save for retirement.
Although most IRAs are unattached to a sponsored employer retirement plan, that isn’t always the case. For example, SEP-IRA’s and SIMPLE IRA’s are both employer sponsored plans which just happen to use the IRA as the individual employee account. When IRA’s are attached to an employer plan (like a SEP or SIMPLE), the plan rules (rather than the ordinary IRA regulations) dictate everything about the IRA, including how much can be contributed into the account each year. No wonder folks find this stuff confusing - because it is!!
4. There’s a difference between employer and employee contributions.
For retirement plans which are sponsored by an employer, there are two different sources from which contributions can be made.
- The employER may make contributions on behalf of the employees; and
- EmployEEs can choose to take a portion of their compensation (e.g. their payroll or salary) and contribute it to their retirement account. This employee contribution is sometimes called an “employee deferral.”
When you’re the business owner (e.g. it’s your private practice — whether solo or group), you act as both the employer and as an employee. That means for your retirement contributions, you have complete control over both employer and employee portions.
Whether it’s an employER or employEE contribution, it’s all your money of course. But the distinction between employER and employEE contribution is important to remember, because the rules are different. Again, I know, this stuff is confusing…
5. Employer contributions come in two flavors: matching and non-elective.
To make matters a bit more confusing, there are two different types of employER contributions. For many (not all) employer-sponsored retirement plans, the employer can choose to make contributions on behalf of employees as either matching contributions or nonelective contributions.
Matching contributions are just that - the employer matches the percent of compensation that the employee elects to contribute to the retirement plan. Let’s say the plan rules stipulate that the employer matches employee contributions up to 3%. If an employee contributes 3% of their compensation, the employer will contribute an equal amount. If an employee contributes 5%, the employer still contributes only 3% - the match is only up to 3%. And if an employee contributes less than 3%, the employer only matches that lower amount. If the employee elects to contribute nothing - the employer will match that nothing and not contribute anything on behalf of that employee.
Nonelective contributions are different. A nonelective contribution takes place regardless of whether the employee contributes anything. Let’s say the plan rules stipulate that the employer makes a nonelective contribution of 2% for all eligible employees. In this case, the employer contributes that 2% regardless of how much the employee contributes. Indeed, the employer must contribute 2% even if the employee decides not to contribute anything.
6. Retirement Plans Can’t Discriminate!
When an employer sponsors a retirement plan, both the Department of Labor and the IRS want to make sure that the employer isn’t using the retirement plan in a discriminatory way. Hence there are a ton of (often confusing) government regulations around retirement plan discrimination.
This discrimination has nothing to do with race or ethnicity - rather, it refers to discrimination on the basis of income (or business ownership).
Regulators wants to make sure that business owners don’t set up retirement plans to benefit themselves, and then leave their employees out in the cold. This is why the moment you hire a W-2 employee, you need to be exceptionally careful about how you operate any employer-sponsored retirement plan. There are very substantial penalties that add up insanely quickly if your business operates a discriminatory retirement plan. This is one area you really don’t want to run afoul of the rules.
Note that 1099 independent contractors are not employees and don’t get factored into retirement plan discrimination provisions. But this is another reason to be very, very careful that you treat 1099s as independent contractors and not like employees! There can be huge penalties otherwise!
Discrimination provisions and the associated calculations are insanely complex. If you’re a solo practitioner, it’s enough to simply know these discrimination rules exist (and you may have to worry about them in the future). If you have employees, I highly suggest working with a professional to administer the details of the retirement plan on your behalf.
If you have no employees in your practice other than yourself, a sponsored retirement plan is reasonably simple and something you probably can DIY with the help of a financial institution like Vanguard.
7. Tax deductions reduce the true cost of your retirement plan.
There is no argument that sponsoring a retirement plan is a meaningful business expense.
But all the expenses you’ll incur are typically tax deductible. That means it will reduce your taxable income and therefore the amount of tax you’ll pay.
If your marginal tax rate (between Federal and state taxes) is 25%, each dollar you pay in higher expenses will reduce your tax bill by 25 cents. That means the net, after-tax expense to you is “only” 75% of the total cost.
That’s a Wrap 🎬
Man, this stuff is confusing.
I’ve done my best to clearly describe these rules. How did I do? I’m not even sure myself haha.
If you still have questions (and I’d be surprised if you didn’t) I’d encourage you to sign up for my next Ask Me Anything “AMA” Office Hours. Totally free and open to any and all therapists looking for the honest thoughts of a fee-only, fiduciary CFP® professional. (That’s me 👋)
Turning Point is a registered investment advisor in the state of California. Please visit turningpointhq.com for important information and additional disclosures. This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes financial, legal or tax advice; a recommendation for purchase or sale of any security; or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Read the full Disclaimer here.