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AAOS Now

Published 5/1/2008
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Frank M. Griffin, MD

Retirement plans: Choose one and invest regularly

When retirement plans make news, it’s usually bad—which is a primary reason for having professional assistance in setting up a retirement plan and for regularly reviewing established plans. You don’t want to approach retirement and get bad news about your retirement plan.

Defined benefits, contributions
Most retirement plans are “qualified plans,” meaning that they meet certain Internal Revenue Service requirements that offer tax advantages to both the employee and the employer. Most plans are either defined benefit or defined contribution plans.

In a defined benefit plan, the retiree receives a specific amount per month as a retirement benefit. The retirement benefit may be either a specific dollar amount or based on a formula that weighs factors such as salary and years of service. The annual employer contributions are calculated by determining how much is needed to fund expected future payouts. Defined benefit plans were once quite popular, but are not commonly used now.

In a defined contribution plan, each employee has an individual account. Depending on the type of plan, both the employer and the employee will contribute to that account. Contributions made to the account are invested, and the returns on that investment are also credited to the account. On retirement, the balance in the account is used to provide retirement benefits. Examples of defined contribution profit-sharing plans include 401(k) and Simplified Employee Pension (SEP) plans.

Profit-sharing plans
A common type of defined contribution plan is the profit-sharing plan. Under profit-sharing plans, the employer can make a discretionary contribution each year; the contribution is allocated among participants based on a predetermined formula. Although these plans are called profit-sharing, companies do not necessarily have to make a profit to make contributions. Various types of profit-sharing plans are distinguished by how the contributions are allocated. Profit-sharing plans include 401(k) plans, age-weighted plans, basic plans, safe harbor 401(k) plans, SEP plans, Savings Incentive Match Plans for Employees (SIMPLE) plans, and others.

In a basic profit-sharing plan, contributions are typically a percentage of a participant’s salary. The percentage can be adjusted by the participant’s age so that older participants receive a higher amount. The cross-tested plan, which may also be called a “new comparability profit-sharing plan,” allows the employer to divide participants into different groups and use different contribution ratios for each group.

Under this type of plan, an employer can maximize contributions to higher-paid employees, based on the idea that these employees generally are older and therefore have fewer years until retirement. Cross-tested plans even provide the opportunity to establish different groups (such as orthopaedic surgeons and nonorthopaedic surgeons) within highly paid employees. To do this, the plan must meet complex discrimination tests, which can result in higher administration costs.

The 401(k) plan is among the more commonly used profit-sharing plans. An estimated 25 million workers are enrolled in 401(k) plans today. These plans hold around $1 trillion in assets.

In 401(k) plans, the employees contribute a portion of their pay to the plan on a tax-deferred basis. Employers may contribute to an employee’s 401(k) account and usually elect to do so up to a certain percentage of the employee’s pay.

Because the government-set contribution limits for 401(k) plans are higher than those for SIMPLE plans and Individual Retirement Accounts (IRAs), participants can potentially realize greater savings than with other types of plans. In 2008, employees can contribute up to $15,500 per year; this limit is gradually increasing. In addition, participants older than age 50 can take advantage of a “catch up” deferral ($5,000 in 2008). However, employers may also set a contribution limit, based on a percentage of salary.

One of the disadvantages of 401(k) plans is that limits on the contributions by higher salaried employees are based on the contributions of lower-paid employees. Average contributions of highly compensated employees, as a group, cannot exceed the average contributions of other employees, as a group, by more than 2 percent. If this threshold is exceeded, and the employer fails to correct the imbalance, the plan could lose its tax-qualified status and all contributions and earnings would have to be distributed to all plan participants.

A safe harbor 401(k) plan operates like a regular 401(k) plan except that the employer designates the plan as a safe harbor at the beginning of the year and employer contributions are immediately 100 percent vested for the employee (meaning that the employee can take the full value of the account when he or she leaves the employer). A safe harbor 401(k) requires the employer to contribute 3 percent of compensation to all eligible employees or to match employee contributions (on a dollar-for-dollar basis for up to 3 percent of salary; at 50 cents on the dollar for the next 2 percent of salary). Administrative costs for safe harbor 401(k) plans are generally lower than those for straight 401(k) plans.

SEP and SIMPLE plans
The SEP is another commonly used plan. The SEP plan allows employers to set up a type of IRA for themselves and for their employees. The employer must contribute a uniform percentage of salary for each employee; employees do not make any contributions. SEP plans are relatively easy to set up and have a low start-up cost as well as low administrative costs. Contributions do not have to be made every year.

SIMPLE plans may be used by employers of 100 or fewer employees. This plan allows employees to contribute a percentage of salary; the employer may also contribute and can match employee contributions up to a certain percentage of the employee’s salary. The employer may also choose to make a fixed contribution for all eligible employees. These plans are relatively easy to set up and administrative costs are relatively low.

Seek professional advice
As an orthopaedic surgeon, you have many options for retirement plans so you should consult a professional to review plan options before making a decision. For example, in addition to the plans discussed in this article, a practice may consider establishing a 403{b} tax-deferred annuity plan, a 457 deferred compensation plan, a defined benefit plan, a nonqualified deferred compensation plan, an employee stock ownership plan, a money purchase pension plan, a cash balance plan, a Keogh plan, or an IRA. Which plan is best for your particular situation is a decision best left to you and your professional financial advisory team.

Frank M. Griffin, MD, has served as a member of the Practice Management Committee and is in private practice in Van Buren, Ark. He can be reached at fgriffin888@aol.com