Working With Professional Services Firms

Art by Katherine Streeter

Working with professional services firms, such as law offices, doctors’ offices, engineering companies or certified public accountants (CPA), on their retirement plan compels advisers to first address the owners’ and partners’ considerations, rather than those of the rank-and-file. These highly compensated employees (HCEs) earning $250,000 or more a year are first and foremost concerned about reducing their tax liabilities since they are in high tax brackets.

Thus, advisers need explain why it makes more economic sense for them to create a retirement plan rather than distribute profits among the partners, says Gregory Kasten, founder and CEO of Unified Trust Company in Lexington, Kentucky. “A retirement plan at a manufacturing or software company, where the owners are in the minority, is going to be designed to be successful for the general workforce,” Kasten says. “At a law firm or doctor’s office, the retirement plan is going to be driven by what the owners want rather than what the rank-and-file wants.”

Advisers need to illustrate to these professionals that rather than pay substantial taxes on profits, it often makes far greater economic sense for them personally to create a cross-tested 401(k) retirement plan paired with a cash balance plan, and then to make the secondary argument that it benefits their employees as well, he says. “They need to be shown why offering a retirement plan is in their best interest and educated about how much more they will need to save for retirement than their administration staff,” Kasten says.

Many CPA and law offices impose mandatory retirement as early as age 60, which makes it all the more imperative for these professionals to plan for their retirement well ahead of time, notes Joe Heider, president of Cirrus Wealth Management in Cleveland.

Advisers should partner with a third-party administrator (TPA) who can illustrate the tax benefits of offering a retirement plan rather than simply sharing profits, says Tom Foster, national spokesperson with MassMutual Retirement Services in Enfield, Connecticut.

In addition, advisers should make the argument that having a retirement plan forces the principals to save, and it might come as a surprise, but high earners are very poor savers when left to their own devices, Kasten adds. “I have counseled hundreds of doctors who have reached retirement, and for 80% of them, the only money they have is what is in their retirement plan. The forced savings aspect of a retirement plan is hugely consequential,” he says.

Paula Calimafde, a partner with Paley Rothman in Washington, D.C. agrees: “Many of these professionals will receive no funds for retirement other than what they inside a retirement plan. As a general rule, professionals will not have stock options, non-qualified deferred compensation plans or even be able to sell their business when they choose to retire, so the plan is critical to their retirement security.”

Maximizing 401(k) Contributions
The first building block of professionals’ retirement plans is a safe harbor 401(k) plan so that the plan complies with nondiscrimination testing and HCEs can reach the Internal Revenue Service individual maximum annual contribution limit of $18,000 plus $6,000 in catch-up contributions for those age 50 and older.

Physicians and lawyers typically work 80 hours a week or more, and for this reason, Merrill Lynch uses auto features paired with goals-based investment portfolios such as target-date funds (TDFs) for the professional 401(k) plans it services, says Chris Barrett, assistant vice president with the firm in Farmington Hills, Michigan. “The first thing we want to do is make it automatic, tax efficient and easy,” he says. “These professionals want to offload as much as they can, so we also relieve them of the 3(16) administrative responsibilities to a third-party administrator.”

Cross-Tested Profit-Sharing Plans
The next option that advisers typically recommend for professional services first is cross-tested profit-sharing plans. These permit $53,000 a year in combined employee and employer contributions for those under the age of 50 and $59,000 a year for those 50 and older, and these significant pre-tax numbers are “very intriguing” to professionals, says Dan Peluse, director of retirement plan services at Wintrust Wealth Management in Chicago.

Cross testing combines profit-sharing contributions with defined contribution plans and allows the sponsor to consider the value of their contributions at retirement, as opposed to in the year they are being made, thereby raising the amount they can contribute to older participants, Heider notes.

Cross-tested plans are also governed by a “50/40” rule, Foster says. “In order for the professional to get the maximum $53,000 contribution, the plan needs to contribute 5% to all employees,” he says. “But if it contributes an additional 2.5%, the sponsor has the option of giving the profits to either 50 employees or 40% of the staff, whichever is less.” And the sponsor gets to select who the recipients will be, he says. For small professional firms of 10 or 12 employees, that 40% option is very appealing because they can give those profits to the partners or the owners, he says.

“If the plan is being administered at a doctor’s office with 10 employees, three of whom are doctors, that 40% rule would allow the sponsor to reward the three doctors plus a key employee,” Foster says. But the sponsor also has the option of taking the money that would have been paid to that one key employee and sharing it equally among the seven administrative support staff. So, it is important to realize that cross-tested plans can be designed with many different variables, which is why Foster believes it is critical for advisers to partner with TPAs capable of making these analyses.

Plan design, particularly with respect to professional services firms, “is a great differentiator for advisers,” he says.

Advisers serving professional services groups, each of which is going to have its own dynamics, definitely need to work with a TPA capable of competent, multifaceted plan design and administration, agrees Andrew McIlhenny, executive vice president at Firstrust Financial Resources in Philadelphia. “They need the flexibility to achieve their goals, not a cookie-cutter plan,” he says.

Cash Balance Plans
Many professional services plans augment their 401(k) with a cash balance defined benefit plan that maintains hypothetical participant balances like a defined contribution plan. The fixed rate of return it earns can vary from year to year. Merrill Lynch recommends cash balance plans to the professional services retirement plans it advises, Barrett says. They give the sponsor the ability to reward participants in the plan as they see fit, which means that doctors can receive substantially more than the rank and file, he says. “The cap is based on the actuarial tables, and the lawyers and doctors can often contribute as much as $300,000 a year,” he says.

Cash balance plans can help highly compensated employees considerably, agrees Chad Johansen, director of retirement ales at Plan Design Consultants, Inc., a TPA in San Mateo, California. “A cash balance plan gives an employer the opportunity to reward HCEs at a higher level than in a 401(k) or profit-sharing plan,” he says. “In a cash balance plan, you have to cover only 40% of the staff, so you can strategically pick what groups of employees have contributions made to their accounts.”

However, the downside is that once a sponsor has a cash balance plan in place, because it is a defined benefit plan, they need to fund it every year.

Other options that advisers can recommend to professional services firms include both a qualified 401(k) plan and a Roth 401(k) plan, says Sherri Painter, director of product management at PNC Retirement Solutions in Pittsburgh. “Those doing more than planning and thinking long term are more inclined to use a Roth component so that they have tax-free money at retirement,” Painter says. The Roth option sometimes takes the form on in-plan Roth conversions, Peluse says.

McIlhenny also recommends that professionals buy insurance. “There are many different insurance-based programs that you can utilize inside of the corporate space, such as a split-dollar plan where you split the benefits of the insurance contract between the employer and the employees.

Depending on how you structure it, there is a win for each party,” he says. “Then there are bonus programs where you leverage the tax-deferred structure of the policy’s distribution mechanisms. Many times, you can have a policy that beneficial to very high-income individuals by maximizing the amount of dollars put inside the insurance contract. Life insurance policies also work well when you tie them into a buy/sell agreement, thereby creating a succession plan.”

Along the lines of insurance, Russell Warye, professional plan consultant with Benefit Partners Financial Group in Libertyville, Illinois, recommends that HCEs take out disability insurance, to protect their income in the event of an accident.

Wayne adds that highly educated doctors and lawyers typically want self-directed brokerage accounts because they think they have the acumen to select individual stocks or exchange-traded funds (ETFs).

Kasten believes self-directed brokerage accounts are a mistake. “I have collected data on self-directed brokerage windows for 25 years, and people who invest in these do worse than those invested in the plan’s diversified offerings 70% of the time, by 4% or more,” he says. “Once we show them their underperformance against the plan, they finally see that they would do better.”

As for nonqualified deferred compensation plans (NQDC), which are popular among HCEs, Barrett says that their tax benefits only work with C-registered corporations, and most professional firms are S-corporations or LLCs.

In sum, there are many retirement plan options available to professional services firms, and as such, advisers need to customize each organization’s plan design with the outcome for both HCEs and non-HCEs in mind.

KEY TAKEAWAYS:

• Unlike typical retirement plans, those geared for professional services are typically driven by the partners’ objectives.
• While doctors and lawyers’ inclination is to share profits among themselves, a retirement plan paired with an auxiliary plan can be more tax advantageous for them.
• Advisers can recommend safe harbor 401(k) plans paired with cross-testing, cash balance plans, Roth options and insurance investments.