Using the correct tax-advantaged retirement plan program at a small or solo law firm is an important long-term planning decision. Participants may save considerable amounts for retirement in a tax-advantaged manner. Further, retirement plans may be an important aspect of transitioning ownership to the next generation of lawyers in a small firm. This article summarizes some attributes of defined contribution plans and defined benefit plans commonly implemented by solo and small firm attorneys, with a focus on using these plans to build a multi-generational workforce.
Benefits of a Strong Firm Retirement Plan
The correct retirement plan brings many taxes, recruitment, and succession planning benefits to you and your firm. Contributions are immediately tax-deductible and enjoy tax-deferred growth until they are withdrawn during retirement. Retirement benefits are also increasingly important in recruiting and retaining top legal talent. Small or solo practitioners owe it to their staff and themselves to implement a comprehensive retirement plan into their firm’s culture.
Beyond the tax benefit and recruiting benefits, retirement plans may be an essential tool in helping a law practice survive beyond the founding partner. Retirement plans may be strategically structured to retain key employees who will gradually take over the business. For example, 401(k) and profit-sharing plans may incorporate vesting and eligibility requirements that incentivize long-term employment. Cash balance plans may accrue substantial benefits to retiring partners, but provide younger employees an extra vehicle for tax-advantaged retirement savings.
Many small firms and solo attorneys often utilize some type of retirement plan. However, they may not be taking advantage of all the options available to them, or their firm may have grown beyond their old plan. It is vital to review personal retirement objectives with business needs to find the best retirement plan option. Let’s review several different types of retirement plans available to attorneys and small firms.
Defined Contribution Plans
A defined contribution plan is a type of retirement plan in which the employer, employee, or both contribute on a regular basis. These plans may be relatively easy to set up, but are flexible to fit the needs of more complex firms. Several of the most common defined contribution plans for attorneys are analyzed below:
Simplified Employee Pension Plans (SEP IRA)
A SEP IRA is a great option for self-employed individuals and business owners who want a simple, tax-advantaged retirement plan. To use this plan, the employer simply contributes a percentage of salary into a tax-deferred account. The percentage of wages contributed must be the same across all eligible employees. This makes things very easy for a solo attorney who must only contribute for themself or small firms with only a few staff (where the administration is easy).
In 2020, up to 25% of compensation up to a maximum of $57,000 may be contributed by the employer. Employers may make SEP IRA contributions up until their tax filing deadline, in contrast to an individual 401(k) plan which needs to be formally established in the tax year in which the deduction will be taken. The simplicity of a SEP IRA is attractive to many small firms and you may still have time in 2020 to set up a SEP IRA to save on taxes for 2019.
Individual 401(k)
Individual 401(k)s work well for solo practitioners or attorneys who have part-time staff working less than 1,000 hours per year. IRS regulations allow these part-time staff to be excluded from a 401(k) plan. For 2020, attorneys may contribute the less of $19,500 as an employee or up to 100% of income. On the business side of the contribution, allowable profit-sharing contributions are based on the net income of a firm and another equation prescribed by the IRS is used to calculate this. However, total employee and employer contributions cannot exceed $57,000 for 2020.
For attorneys older than age 50, additional catch-up contributions of $5,500 may be added to the plan. This option is not available in a SEP IRA, so this is one advantage to using an individual 401k. It may be possible for lawyers age 50 and over to save up to $63,500 per year in a tax deferred manner.
Small Business/ Group 401(k)
As a law practice grows, additional attorneys and staff will likely join. At this point, evaluating and designing the right retirement plan is more critical. A retirement plan is now an important part of overall compensation and retention for employees.
In a group 401(k) plan, employees will be able to contribute up to $19,500 (those age 50 and older can contribute the additional $5,500). However, employers must now set rules on the employer contributions to a plan. By offering a generous employer match or contribution, small firms may boost employee participation and increase their retirement savings. Vesting and participation rules may be added to these 401(k) plans. Most firms utilize such vesting schedules to encourage employees to stay with the firm for a minimum period of years before becoming fully vested in the retirement account balance. Strict guidelines must be followed in setting up an employer match and many firms decide to elect simplified IRS “safe-harbor” provisions.
Running a group 401(k) requires more administration than a SEP IRA, but many outside service providers will efficiently set up a 401(k) plan and integrate it with payroll. Financial advisors may be used to help design the plan and select available investment options. An accountant will ultimately be able to decide how much should be funded on an annual basis to ensure maximum deductibility.
Defined Benefits Plans: Cash Balance Plans for Small Firms
Defined contribution plans such as a SEP IRA and 401k plan are a great way to begin saving for retirement and relatively easy to setup. However, higher-earning attorneys and more sophisticated firms may set up additional qualified retirement plans that provide considerable tax savings. Many small law firms sponsor a type of defined benefit plan known as a cash balance plan.
Cash balance plans allow partners to supplement their profit-sharing 401(k) plan with an additional deductible contribution for themselves, and a likely smaller contribution for their staff. The amount of the contribution is dependent on a partner’s age and salary, but older partners approaching retirement may be able to put away up to $200,000 a year into a tax-deferred account.
The cash balance option is popular with small law firms because they allow for varying levels of contributions between partners and employees. From a multi-generational perspective, the cost of funding a cash balance plan for younger associates may be quite low, and this can prove to be an important employee benefit that sets a law firm apart from its competitors.
A cash balance plan is not for everyone, and they are much more complex than 401(k) plans to administer. These plans require actuarial assistance, and are also subject to annual funding requirements. Nonetheless, these plans are especially advantageous for high-income professionals who can afford the costs to both set up and administer them.
Conclusion: Retirement Benefits Are Critical to Small Law Firm Success
When a retirement plan is available to employees, the majority choose to take advantage of it and join the plan. There is no “one size fits all” solution, and firms must review what is best for them. Preferably, firms will choose a retirement plan program that embeds succession planning in firm management and can be used to motivate a successful multi-generational workforce.
Using the right retirement plan may allow substantial benefits to be accrued as one generation transfers ownership to the next. Partners can shield substantial income from taxation through their working years and enjoy the results of tax-deferred retirement savings. These plans can also have the ancillary benefit of functioning as a retention tool for valuable employees by using delayed plan eligibility and vesting provisions.
About the Author
Frederic Behrens is an attorney, and director and wealth advisor with Round Table Wealth Management, an investment management and wealth management firm.