If you've ever attempted to set up a retirement plan through your private practice, I'm guessing it was a pretty frustrating experience. They are complex and confusing things.
I believe a big part of the challenge with retirement plans - and so many other aspects of the financial world - is that it's like diving into a 500-level course when you've never been given the opportunity to attend the 101.
Well - no more! (For retirement plans at least).
This post kicks off a series about retirement plans. And where do we begin? With Retirement Plans 101 of course!
Now, I'll admit. This material is a little bit... dry. It's not the most exciting. But that's actually a good thing. When it's dry and boring - it's also low anxiety. And that's the best time to learn.
So let's get started!
Retirement Plans 101: Foundational Concepts
Retirement plans and retirement accounts are confusing and detailed things. Here I’ll outline a few of the basics. A lot of this might feel like arcane details. But understanding these basics is essential to make informed decisions (not to mention avoid money anxiety and overwhelm!)
Three topics I’ll cover here:
- Sponsored Retirement Plans versus Individual Retirement Accounts
- Employer contributions versus Employee contributions
- Discrimination provisions
Sponsored Retirement Plans versus Individual 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 an 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!!
Employer contributions versus 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), you are both the employer and an employee. That means you have complete control over both employer and employee contributions.
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…
Discrimination Provisions of Retirement Plans
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. This discrimination has nothing to do with race or ethnicity - rather, it refers to discrimination on the basis of income (or business ownership). Here, I’ll collectively refer to the Department of Labor and IRS as “the government.”
The government 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 - otherwise there can be huge penalties from both state and Federal levels of government.
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. Note your business (e.g. practice) can employ your legally married spouse without having to worry about discrimination provisions. For better or worse, the government doesn’t consider your legally married spouse to be an outside employee.
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Retirement Plans 102: When you have Employees
If you already have employees and are looking to establish a retirement plan, there are a few more important details you’ll need to understand. Specifically we need to talk more about discrimination provisions and employer contributions. We’ll wrap things up by talking about newer “safe harbor” type plans which make all this simpler, easier and - in most cases - less expensive for small business owners.
Retirement Plan Discrimination Testing
The government wants to make sure retirement plans aren’t operating primarily for the benefit of business owners and other highly compensated employees. For that reason, the discrimination testing provisions exist.
Specifically, the discrimination calculations ensure that the plan fairly benefits non-Highly Compensated Employees (HCEs). HCE’s are generally those employees in the top 20% of compensation and anyone who owns more than 5% of the sponsoring employer. Both the full definition of an HCE and the exact nature of this discrimination testing is way beyond the scope of this article, and better left to the accountants and attorneys. Best of luck to them.
Guess what? It’s super common for small business to fail these discrimination tests. What happens then? You can fix (or “cure”) the test failure by making an employer contribution to each non-Highly Compensated Employee’s plan account.
And that brings us to the next topic we need to discuss a bit more: employer contributions.
Matching Contributions versus Nonelective Contributions
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.
Remember how many small business retirement plans fail those discrimination tests? The easiest way to fix that failure is to make a nonelective contribution to the accounts of all non-Highly Compensated Employees. But what if there were a simpler way to pass the discrimination test? Good news - there is!
Safe Harbor Plans to the Rescue
Recognizing that all this is testing and after-the-fact employer contributions to fix failing those tests is a lot of rigamarole (technical term), legislatures introduced “safe harbor” retirement plans. The two most relevant for small business owners are SIMPLE IRA’s and Safe Harbor 401(k)’s.
These “safe harbor” plans allow you to skip all the complex testing if you follow the rules they put in place. The two most important rules are mandatory employer contributions and immediate vesting in employer contributions.
These safe harbor plans require annual employer contributions. These contributions can be either matching or nonelective, but the percentage of compensation is specified and must be paid on behalf of all employees annually.
Safe harbor plans also require that employees are immediately vested in all employer contributions deposited in their accounts. More complex, non-safe harbor retirement plans allow multi-year vesting schedules before employees fully own the employer contributions in their account. (Note that employees are always fully vested in their own employee contributions because this was always their money - they simply chose to direct some of it into the company retirement plan.)
One final characteristic of these safe harbor plans: they generally require most - and in many cases all - employees are included. More complex, non-safe harbor retirement plans allow more (though not much) flexibility in excluding certain classes of employees.
That's a Wrap 🎬
That's it for this today's post. I know we covered a lot and yet it is but one small part of navigating the entirety of your financial life.
If this all feels a bit much, give me a shout. I work one-on-one with therapists from all over the country helping them address issues just like the ones we talked about today! Learn the different ways you might work with me on my services page.
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.