By Joseph Nicola, J.D., CPA
Setting up a retirement plan is one of the most challenging aspects of operating a physician’s practice. Physicians often use retirement plans to shelter as much of their income as possible, while providing employees with appropriate help on their retirement. Unfortunately, most practice groups establish plans that are restrictive and inflexible, and typically result in the physicians getting a smaller share of the annual plan contributions than is otherwise available under the law.
For example, in a profit-sharing plan, typically a 401(k), the contribution for all qualified employees is often a pre-established percentage of compensation. The percent must be the same for all employees, and cannot be more than 15 percent. There is also a cap on qualified compensation of $160,000, which means that the maximum contribution for each employee is $24,000. In a practice group with two physicians and twelve other qualified employees each averaging $35,000 in salary, the physicians would find that their share of plan equals just 43 percent of the total contribution of $111,000.
Unknown to most physicians and other business owners is a relatively obscure provision of the IRS regulations called “new comparability cross-testing,” which enables the physicians to increase the amount they can contribute to their retirement plans.
As a general rule, under the Internal Revenue Code, employer contributions to a qualified retirement plan are required to be allocated to all participants in a uniform manner. Most practices achieve this result by making a simple employer contribution to the plan on the basis of a percentage of compensation. The IRS regulations provide numerous examples that advocate this simple approach. This approach also is advocated by many pension and benefits experts.
Among all of these authorities, however, there is very little guidance regarding the cross-testing technique. The primary authority is a single paragraph in the IRS regulations that defines the technique and provides an example. The provision is buried within the voluminous text of the nondiscrimination regulations, and complexity is evident. Consequently, few tax and accounting practitioners have been willing to advocate a cross-testing technique. This is most unfortunate, since the IRS has issued several administrative interpretations that attempt to clarify the methodology and thus place an imprimatur on increased discrimination.
New comparability cross-testing helps the practice group appropriate the total plan pie in a manner that is more reflective of the contributions made by the physicians and other employees to the short- and long-term financial success of the practice group.
In theory, the first step in new comparability testing is to establish the total contribution amount for the year. This is a figure that is often determined as a part of corporate income tax planning. That is, the corporation’s taxable income is projected for the year. After this determination is made, the physicians then typically determine the amount of the proposed employer contribution to the plan for the year. After the year ends, this figure may then be refined to accommodate final elements of tax and benefits planning. The result will be the total amount to be made available for contribution to the practice group’s retirement plan.
The total group contribution is then allocated to qualified employees based on a fairly simple point system. Points are allocated to the physicians and their employees on the basis of such criteria as job title and years of service. For example, a physician would get more points than a records clerk and someone with ten years of service would get more points than someone with three years service.
The total contribution is then divided up according to the point system. Using the point system, the allocation to each physician’s account will almost certainly exceed the maximum permissible allocation using the simple 15 percent approach mentioned above. In fact, it is possible that the allocation to each physician’s account may approach $30,000, although it may be necessary to install a money purchase pension plan to get to this result. This is because the law limits the amount of the total annual employer contribution to a profit sharing plan to 15 percent of total aggregate compensation of all employees. Moreover, the maximum amount of compensation that may be considered in computing the contribution to a participant’s account is limited to $160,000. Thus under a simple 15 percent formula, the following results might be achieved in the case of a profit sharing plan:
• Participant A: $160,000 compensation, $24,000 contribution.
• Participant B: $160,000 compensation, $24,000 contribution.
• Participant C: $40,000 compensation, $6000 contribution.
• Participant D: $30,000 compensation, $4500 contribution.
• Participant E: $20,000 compensation, $3000 contribution.
In this case, the total employee contribution of $61,500 cannot, and does not, exceed 15 percent of the total aggregate compensation of $410,000.
Conversely, a money purchase pension plan would permit an employer to make an annual contribution of up to 25 percent of the total aggregate compensation for the year. However, no more than $30,000 may be contributed annually to any one participant’s account. Thus, in the above example, the total annual contribution can be increased in such a way as to increase the allocation to each physician’s account to $30,000 as follows:
• Participant A: $160,000 compensation, $30,000 contribution, 39 percent.
• Participant B: $160,000 compensation, $30,000 contribution, 39 percent.
• Participant C: $40,000 compensation, $7500 contribution, 10 percent.
• Participant D: $30,000 compensation, $5625 contribution, 7 percent.
• Participant E: $20,000 compensation, $3759 contribution, 5 percent.
As can be seen, 39 percent of the total contribution is allocated to each physician’s account. Thus, assuming the installation of a simple money purchase plan, the annual contribution to each physician could reach $30,000.
The addition of the cross-testing feature can increase the percentage of the total contribution that is allocated to the physicians’ accounts. For example, let’s say that the total number of points of all qualified employees is 99 and each of the two physicians has 44 points. In this scenario, if the practice group makes a contribution of $75,000 for the year, each physician would receive an allocation of $30,000. The contribution to the physicians’ accounts in this scenario would represent 88 percent of the total contribution for the year.
As a practical matter, the process is reversed in year-end planning. By assigning the point totals first, the physician group knows how much to allocate in order to reach the contribution goals of the physicians.
New comparability cross-testing offers physician practice groups the flexibility that virtually all other retirement plan structures lack, especially when it is combined with “Social Security integration,” which is a means by which to increase further the allocation of an annual contribution to the physicians.
Under Social Security integration, the law permits an assignment of additional points to participants who earn an annual salary that exceeds the Social Security wage base ($68,400 in 1998 and $72,600 in 1999). The excess over the wage base is effectively converted to additional points. Moreover, unlike new comparability cross-testing, which relies on such factors as title, years of service and age, Social Security integration focuses strictly on salary.
For example, a conventional cross-tested plan generally will favor older physicians. Social Security integration mitigates this effect. Consequently, a cross-tested plan that is integrated with Social Security usually produces more desirable results. Using the facts in the example above, the following allocation would result using Social Security integration:
• Participant A: $160,000 compensation, $30,000 contribution, 47 percent.
• Participant B: $160,000 compensation, $30,000 contribution, 47 percent.
• Participant C: $40,000 compensation, $1900 contribution, 3 percent.
• Participant D: $30,000 compensation, $1275 contribution, 2 percent.
• Participant E: $20,000 compensation, $625 contribution, 1 percent.
Note that 94 percent of the total contribution is allocated to the physicians.
When used aggressively, new comparability cross-testing enables physicians to maximize their retirement plan contributions while at the same time reducing the total contribution for the year. As with any retirement plan structure, however, the rules are complex and limitations may apply. For example, the Internal Revenue Service has established parameters that limit the point spread between the highest and the lowest compensated of all qualified participants.
The focus of those limits is on the projected annual benefits that a participant is expected to receive at retirement. The expected result (i.e. the annual benefit) is then expressed as a percentage of the participant’s current salary. As long as the average of the nonphysician percentages is within a given range, the plan will pass the IRS discrimination tests. The average of the nonphysician percentages is often quite high, especially when the staff is younger. Consequently, the IRS discrimination tests can easily be satisfied.
It is clear that a cross-tested plan can substantially increase a physician’s ability to save for retirement. Unlike an IRA or a Roth IRA, both of which limit annual contributions to $2000, the cross-tested plan permits the typical physician to save up to $30,000 annually. One should note, however, that a nondeductible IRA or Roth IRA contribution of up to $2000 can nonetheless be made annually to a physician’s personal IRA or Roth IRA account, as long as the physician qualifies. Such a contribution would be in addition to the contribution to the retirement plan of the practice. Thus, the concept of the IRA or Roth IRA should not be ignored simply because of the limits on deductibility or on the amount that can be contributed every year, especially since earnings grow tax-free in an IRA or Roth IRA environment, and distributions may be partially or wholly tax-free.
The cost for establishing a retirement plan based on new comparability cross-testing is surprisingly low. A plan based on standard documentation can cost well under $1000 to set up. The fees to administer the plan and go through the process of assigning points each year are also quite reasonable.
Joseph Nicola, JD, CPA, is an accountant with the Pittsburgh accounting firm of Alpern Rosenthal & Company.