By Adam Cmejla, CFP®
Nov. 10, 2021
How you use the cash flow that’s generated from a practice will largely dictate the return on investment that you get on your net income. You won’t necessarily become (and stay) rich by selling your optometry practice, but you can confidently use the cash flow that’s generated from a practice to build wealth in multiple ways.
While we often recommend that ODs first and foremost invest back into their own business, it doesn’t mean they should neglect other vehicles that can help them build wealth independent of the value of their practice. I often refer to an optometry practice as a chassis in which you can bolt on a retirement body to serve as the vehicle to build wealth.
For younger practice owners, this often starts with either a SEP (Simplified Employee Pension) or a SIMPLE IRA. SEP IRA contributions are made with 100 percent employer contributions while a SIMPLE IRA combines both employee and employer contributions.
While the SIMPLE IRA looks and feels like a 401(k), it has a few notable differences that, over a practice owner’s lifetime, can have a significant impact. Below, I’d like to share several reasons why not switching to a 401(k) and staying with a SIMPLE IRA can have a significantly negative impact on your overall wealth-building journey.
To Roth or not to Roth…that is the question
An important distinction between the SIMPLE IRA and 401(k) is that the SIMPLE IRA does not have a Roth option. The notable difference between a Roth IRA/Roth 401(k) compared to a Traditional IRA/Traditional 401(k) is that an individual pays taxes on dollars going into a Roth instead of getting a tax deduction upfront like they would on a Traditional plan. However, the balance of a Roth IRA/401(k) grows 100 percent tax free and qualified distributions are also tax free.
The goal of a practice owner should be, from a taxability point-of-view, to fill up three different pools of money in retirement that, in combination, can provide their retirement income: a tax deferred pool (Traditional IRAs & 401(k)s), a taxable pool (brokerage accounts, net income from real estate, etc.) and a tax-free pool (Roth IRA and Roth 401(k)). The reason we want this to be a goal is because it demonstrates asset and income location throughout their working career: the practice owner is being strategic annually about how, where and when income shows up on their tax return.
If a successful practice owner continues to fund a SIMPLE IRA, they are all but guaranteeing that their Roth (tax free) pool will remain empty their entire career. This is because of income phase-out limits that apply to Roth IRA contributions. In addition, the assets they have in their SIMPLE IRA will preclude them from making “backdoor” Roth IRA contributions. (For more information on why this is true, taxpayers can read the instructions for tax Form 8606).
Increased Contribution Limits…
Graduating from a SIMPLE IRA to a 401(k) also allows practice owners to contribute a higher annual amount. The SIMPLE IRA limit in 2021 is $13,500 + an additional $2,500 catch-up contribution for those over the age of 50. The 401(k) limit is $19,500 + an additional $6,500 catch-up limit for those over 50.
In addition, this now allows a practice owner the opportunity to fund “backdoor” Roth IRAs (via a non-deductible Traditional IRA contribution and subsequent conversion; again see Form 8606 instructions mentioned above). In 2021, the annual IRA contribution limit is $6,000 + an additional $1,000 for those over the age of 50.
In totality (and should they choose to defer 100 percent of their contributions into Roth accounts), transitioning from a SIMPLE to a 401(k) can allow a practice owner over the age of 50 to save an additional $16,000 in a potentially tax-free Roth account.
Why is this so important and how does this manifest itself into a practice owner’s retirement goals?
…leads to potentially higher monthly retirement income
With all the focus on investments, wealth building, saving and net worth statements, it’s easy to lose focus on what we’re trying to accomplish. As I wrote in my last article, the goal of building wealth isn’t to have it sit on your balance sheet (net worth statement). The goal is to shift/transition those assets into income streams in retirement.
For example, let’s run the math on the following hypothetical situation. Let’s take an optometric practice owner that, at the age of 40, decides to “step up” from a SIMPLE IRA to a 401(k). Let’s make the following assumptions:
- Max funds his 401(k) each year.
- Once he reaches the age of 50, he also funds the catch-up contribution of $6,500.
- He does this until age 65 (25 years).
- Assume a 7 percent compounded annual rate of return on the portfolio.
- Disregard any previous balance in the SIMPLE IRA. This example is just looking at the difference between the two savings vehicles.
What’s the impact of these changes compared to staying the course with a SIMPLE IRA?
- SIMPLE IRA balance at age 65: $1,628,175
- 401(k) balance at age 65: $2,419,775
If you looked at the difference between both values ($791,600) and think it to be a big deal, you’d be correct. However, I’d like to take it one degree further. Let’s look at how that translates into monthly retirement income/distributions off the portfolio.
Assuming a 4 – 5.3 percent distribution rate off the portfolio, this translates into between $31,664 – $41,954 of retirement per year ($2,638 – $3,496 per month) throughout retirement. Take your own situation right now and ask yourself: “What could I do in retirement with a potential extra $2,600 – $3,400 per month?”
Avoid Being Penny-Wise, Pound-Foolish
At the risk of coming off harsh and insensitive to costs, let me address the fact that 401(k) plans DO come with higher expenses than SIMPLE IRAs. There are record-keeper, third-party administrator, custodial, and possibly other fees, to consider.
All-in, a 401(k) will usually run about $1,500 – $2,500 per year in expenses to the employer, not to mention possible annual expenses to each participant that may range in the $19-39/year range. This is also excluding investment fund expense fees, but I’m largely ignoring them because both SIMPLE IRAs and 401(k) investments have fund expense fees associated with them. I’m sure there are ODs out there paying less or more—after all, the qualified plan environment is still somewhat the “wild, wild west” when it comes to transparency and parity in platforms.
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However, given just the difference in the amount that you can contribute, I think it’s safe to say that “the juice is worth the squeeze”—the long-term wealth creation opportunities outweigh the costs of the plan.
The Time to Act is Now
If I’ve successfully persuaded you to evaluate a 401(k), the clock is ticking. If you plan on switching from a SIMPLE IRA to a 401(k), you must give your employees notice about the plan change at least 60 days in advance of the change. Since you (a) cannot have another retirement plan in the same year you have a SIMPLE IRA and (b) if you make a contribution to a SIMPLE IRA at any point throughout the year, you are effectively locked into the plan for the remainder of the year. Your certified financial planner and the 401(k) partner you choose can help you with this process.
If you didn’t make the decision to act before November 1, 2021 you can still start a 401(k) in 2022. The most important caveat to remember is that you cannot make ANY “current year” contributions to a SIMPLE IRA in 2022. Doing so will effectively “lock you into” the SIMPLE for another year. But if you don’t get the notice out to your team members that you’re switching until 12/1/2021, the 401(k) won’t go into effect until 2/1/2022.
Conclusion
While the transition to a 401(k) from a SIMPLE IRA isn’t needed to build wealth through practice ownership, it’s one way to level-up an already-powerful savings vehicle: the retirement plan in your practice. As with most financial decisions in your practice, there are benefits and exchanges to either decision. The key is having the clarity and confidence to know the implications of the decision—both for your current and future self.
For an audible version of this topic, check out episode #92 of the “20/20 Money Podcast” wherever you get your podcasts).
Adam Cmejla, CFP® is a CERTIFIED FINANCIAL PLANNERTM Practitioner and Founder of Integrated Planning & Wealth Management, LLC, an independent financial planning & investment management firm focused on working with optometrists to help them reach their full potential and achieve clarity and confidence in all aspects of life. For a number of free resources, visit https://integratedpwm.com/ebooks/ and check out the “20/20 Money Podcast” to get more tips on making educated and informed financial and business decisions.
