Katie Collins, a Practice Integration Advisor with Buckingham Strategic Wealth, helps dentists order their financial lives and reach financial peace of mind so they can better focus on what truly brings them joy.
A practice transition has both an emotional side and a financial side. Every dentist has a different emotional reaction to the transition process – as they should – because it’s a very personal event. However, there are a few common financial themes. One involves strategies for utilizing your pension plan to help reduce the tax bill from the sale. This is a thing? Yes, but it should be discussed thoroughly with your pension plan’s third party administrator (TPA), your accountant and your financial advisor. While it’s a common strategy, it is also specific to your unique situation.
In a practice transition, we generally encourage dentists to sell their practice’s assets. This allows them to allocate the purchase price among goodwill, equipment, furniture and fixtures, supplies, etc. Goodwill is a personal asset and you will pay capital gains taxes (instead of ordinary income taxes) on it.
The remainder of the practice purchase would flow through the practice entity. This represents the portion of practice sale proceeds that may be available to fund your pension plan. We generally target these funds because a seller will pay ordinary income taxes on them, most likely ending up in the highest tax bracket. So, how do you begin thinking about this? Start by looking at how much of the practice sale proceeds will flow into your practice entity. Talk with your financial advisor and your accountant about how much might be available for pension funding.
Next, look at your current pension strategy. Dentists with a 401(k) profit sharing plan for the practice should consider using a portion of their practice sale proceeds to maximize a profit-sharing contribution for themselves and their staff in the year the practice is sold.
The route that piques a lot more interest, however, is utilizing practice sale proceeds to fund a cash balance defined benefit plan. The contribution limits are higher with such a pension plan than with a 401(k) profit sharing plan. This is a much more complicated strategy, though, and I’d recommend having qualified advisors to help you through it. There are two avenues to follow with the pension strategy.
If you currently have a cash balance defined benefit plan, and have had it for three or more years, you can talk to your TPA about increasing the funding formula for the year in which you sold your practice. You should discuss your funding target with your accountant and your financial advisor as you talk to your TPA. How much should you fund into the cash balance plan? This strategy could allow you to make a significant contribution that will help reduce your tax bill in the year your practice is sold.
If you don’t currently have a cash balance defined benefit plan, this strategy may come with a longer lead-time to implement. We generally recommend that a dentist who wishes to set up a cash balance plan keep it open for at least three years. Therefore, if you would like to have the opportunity to use a portion of your practice sale proceeds to make a larger pension contribution, consider launching this strategy at least three years before you sell your practice. We don’t recommend calling your advisor the day after your practice sale and asking about funding a cash balance plan you have yet to open. In our opinion, this is a big red flag and you run the risk of the IRS disallowing the plan.
While there are a few avenues to utilize your practice sale proceeds to fund a pension plan, recall that doing so is a very specific strategy and each dentist has different needs. We highly recommend that, if this sparks some interest on your part, you reach out to your current financial advisor to talk about your individual circumstances and how one of these strategies might meet your financial needs.
In our next post, my colleague, Tom Bodin, will discuss approaches to evaluating how much life insurance you need. As always, if there are specific topics you’d like us to tackle in Finance32, please send us an email!