August 01, 2016 Feature

Retirement Planning for Lawyers

Christine Hotwagner

Here’s a big word for you from the world of behavioral finance: hyperbolic discounting. Hyperbolic discounting is a time-inconsistent model of discounting. Okay, that didn’t help much. Think of it this way: Humans have a tendency to value short-term rewards over longer-term rewards, even when mathematically the rewards are worth the same. The farther away the reward is, the more we tend to discount it.

How does it work? Assume someone has the choice between $20 now and $100 tomorrow. Most will wait a day and collect the $100 reward. But what if I were to offer you $20 now or $100 a year from now? Turns out many people will opt for the $20 now, discounting the value of a larger reward because it is so far into the future. So expressed another way, hyperbolic discounting is a person’s desire for an immediate reward rather than a higher-value reward at some point later.

Okay, let’s test your newly acquired knowledge. You have $650 left in your pockets, and the new iPhone just came out. What do you value more, the new phone now, or the thousands of dollars your pocket money might grow to become by the time you retire 30 years from now?

Turns out you don’t have to be a lawyer to understand this concept because it affects everyone the same. And that’s why legal professionals, just like everyone living in today’s society, struggle to plan ahead and save adequately for retirement. So what can you do today to help ensure you’ll have what you need tomorrow? The short answer is—take action today!

Establishing a Plan

As a sole practitioner or small firm owner, taking action may mean a few things. On the one hand, you need to establish a plan. This means you need to understand your responsibilities as a plan sponsor, especially as related to eligible employees if you have them. On the other hand, you have to think about saving for your own retirement.

Statistics have shown that people are much more likely to save for retirement if a retirement plan is available to them through the workplace. However, access to such plans has been a challenge when it comes to smaller employers, who typically choose not to sponsor a plan. Of all small employers—those with ten or fewer workers—only 16.5 percent sponsor a retirement plan, according to an Employee Benefit Research Institute estimate. This is especially noteworthy in light of the fact that, according to the latest statistical report by the American Bar Foundation, nine in ten lawyers work for firms that have fewer than ten attorneys. The propensity for law firms to be small means that having access to a workplace retirement plan is especially challenging for most law professionals.

If you’re not already sponsoring a retirement plan and don’t know what to do, think about your key objectives. Do you want to minimize cost to your firm? Are you looking to attract and retain valuable employees? Or do you simply want to maximize tax-advantaged benefits? Based on your key objectives, there may be several different retirement plan options that fit your needs. The right option can depend on the size of your firm and your preference for contribution eligibility, administrative responsibility, contribution limits, fiduciary exposure, access to the savings, and costs to maintain the plan. Some of the more common options for small law firms include a simplified employee pension individual retirement account (SEP-IRA), a savings incentive match plan for employees individual retirement account (SIMPLE IRA), and a 401(k).

SEP-IRAs are for self-employed individuals or small business owners, including those with employees. They are easy to set up and maintain and typically have no or low initial setup or annual maintenance fees. Only employers can contribute to this plan, and although employees can withdraw funds at any time, a 10 percent penalty may apply if the withdrawal is made before age 59 ½. Employer contribution is limited annually to the lesser of 25 percent of compensation or the Section 415 limit of $53,000 in 2016. Employers must contribute the same percentage of compensation for all employees, including themselves.

SIMPLE IRAs are ideally suited as start-up retirement plans for small employers not currently sponsoring a retirement plan. Employer contributions are required, and employee deferrals are optional. Participants can withdraw funds at any time, but a 10 percent penalty may apply if they are under age 59 ½. This penalty can increase to 25 percent if the withdrawal is made within the first two years of the plan being established. This type of plan is typically low cost to both the employer and employees. Employers can either make dollar-for-dollar matching contributions not to exceed 3 percent of participant’s compensation, or a 2 percent non-elective contribution to all eligible employees, regardless of whether they make deferral contributions. Employee contributions are limited to a maximum of $12,500 in 2016 (employees age 50 and older can make a catch-up contribution of up to $3,000).

401(k) plans are for companies of all sizes. They allow generous contribution limits and the most flexibility in plan construction. Both employers and employees contribute. Loans may be available and hardship withdrawals may be available, but a 10 percent penalty may apply if the employee is under age 59 ½. A 401(k) plan is typically slightly more expensive than a SEP-IRA or SIMPLE IRA, but cost can vary from provider to provider. The 2016 contribution limit of $53,000 applies, and the maximum employee contribution allowed is $18,000 (employees age 50 and older can make a catch-up contribution of up to $6,000).

If you are a true sole practitioner with no staff, you also may consider a straight profit-sharing plan that allows for annual discretionary contributions. Because these contributions are not required, profit-sharing plans can be especially useful when income is uncertain. On the other hand, you are allowed a maximum contribution of the lesser of 100 percent of compensation or the $53,000 (2016 limit) mentioned above. A true sole practitioner who has the potential and desire to put even more away for retirement may consider a defined benefit plan. These plans must, however, be funded annually and work best for individuals over 50 who want to accelerate their retirement savings. Contributions must be calculated annually with the help of an actuary. Although this may entail some additional cost, it generally is offset by the increased contributions and associated tax benefits.

Before selecting a plan for your firm, you should have a thorough understanding of its cost, which can include costs to your firm as well as costs to your participating employees. There are several types of fees a retirement plan provider can use to collect revenue. All these fees can quickly add up to thousands of dollars, which can erode the profits of your law firm and negatively impact an employee’s retirement savings. A good place to start if you’re already sponsoring a retirement plan is by reviewing your plan’s 408(b)(2) disclosure, which requires annual disclosure by retirement plan service providers to plan sponsors and fiduciaries of fees charged, services provided, and information on other compensation received.

All this is not necessarily an easy process to navigate. If you find yourself struggling through the process, don’t worry. There are knowledgeable financial professionals who specialize in retirement plans. A qualified advisor or consultant can help you determine what’s best for you and your firm, explain how various retirement plans can deliver on those objectives you’re looking for, and even assist you in finding and evaluating suitable providers. You can even find online tools that can help orient your decision making when it comes to selecting the right retirement plan that fits your needs and the needs of your firm.

Following Through

Now let’s get back to the behavioral side of this equation. If you’ve read this far, you’re probably like most working Americans and see your SEP-IRA, SIMPLE IRA, or 401(k) plan as the cornerstone to your retirement savings. But if you’re not, and you believe you’ll never retire from practicing law, consider this: One in five retirees do not retire on the planned-for date because of illness or health issues. One of life’s realities is that with old age comes a variety of health concerns that may impact your ability and willingness to practice law. Often law professionals are forced into retirement owing to ailments or health conditions. The uncertainty about what your health has in store for you down the road is cause for planning. So whether you plan to retire or not, consider just a few simple tips that can help you be ready to retire with the dignity and financial security you expect and deserve.

Tip #1: Participate in your plan. If you haven’t yet enrolled in your retirement plan, make it a point to do so now. People are living longer now than ever before. According to a report by the U.S. Census Bureau, the United States is projected to have 9 million people above the age of 90 by 2050—up from 1.9 million in 2010 and only 720,000 in 1980. This means our nation’s 90-and-older population has nearly tripled over the past three decades . . . and is projected to quadruple over the next four decades. These longer life spans, coupled with spiraling health care costs, the uncertain future of Social Security, and the decline of public pensions, means individuals are increasingly responsible for funding their own retirement.

Contributing to a retirement plan can put you on the right track to be able to fund your retirement years. The money you contribute is tax-deferred from both federal and state income taxes, which means you don’t pay taxes on the contributions until you withdraw the funds, typically at retirement age. Furthermore, contributions to the plan are deducted automatically from your paycheck, making the process seamless for you.

For law professionals this tip is especially important. The law profession is characterized by busy, time-consuming schedules with little time for planning outside of work. As a result, law professionals compulsively push off the decision to start saving. As inertia sets in, many people are left feeling as if their bank account was a ticking clock and too few years remain until retirement.

If you’re unsure about how to get started, take advantage of the many helpful online tools and resources available to you, such as Voya’s myOrangeMoney retirement calculator (voya.com). These tools offer an easy way for you to determine how much you need to save to reach your retirement goals and how different contribution rates will impact your retirement savings.

Tip #2: Take advantage of matching contributions. If your plan offers a company match, take advantage of it! This is a valuable benefit where your employer will match your contributions—typically capped at a percentage of your pay. For example, a company may offer a dollar-for-dollar match up to 3 percent of pay or a 50 percent match up to 6 percent of pay. Find out what your employer will match and, at the very least, contribute enough to take advantage of the match.

Many law firms will offer generous matches and sometimes profit-sharing plans where the employer has discretion to determine when and how much the company pays into the plan. The amount allocated to each individual account is usually based on the salary level of the employee.

Tip #3: Make catch-up contributions. If you are age 50 or older (or will be by the end of the calendar year) and your plan allows, take advantage of the “catch-up” provision noted above. For example, if you are 50 years old this year and haven’t started saving for retirement, the catch-up provision will allow you to contribute nearly as much as $250,000 over the next ten years—tax-deferred—to a 401(k) plan. When you consider the potential of compound earnings, this can add up to significant savings.

Tip #4: Keep your savings working for you. Even if you are allowed to borrow from your plan, think twice before doing so. Although it may sound appealing, borrowing from your retirement plan reduces the benefit of tax-free compounding that is the key to building up savings. Before you make the decision to take a loan, there are a few considerations to take into account:

  • You will pay interest on the loan with after-tax dollars, thereby losing the tax advantage.
  • You will pay taxes a second time when you eventually withdraw the money in retirement.
  • Interest on the loan is not tax-deductible, even if funds are used for a home purchase.
  • Most loans must be paid back within five years, but if you leave your job, the loan must be paid back in full immediately or the amount becomes a taxable withdrawal.

Tip #5: Invest for the long term. Once you set your investment allocations, be patient. Predicting the market is not like predicting the weather. There are no high-tech gadgets or radar systems to predict the highs and lows that may lie ahead. It’s critical to remember that what is important is time in the market, not timing the market. Discipline yourself to maintain your allocation through down markets as well as up markets. Having a properly diversified portfolio will help make any market swing easier to digest. Conduct an annual review of your plan to confirm your allocations still align with your life stage and economic circumstances.

Tip #6: Consider spending time with a financial professional. According to Voya research, those who spend time with a financial professional save more than their peers who do not, with greater investment knowledge and confidence in their ability to enjoy retirement. If you have never received help from a financial professional before, this is something to consider pursuing.

Planning to Succeed

Many things require planning—purchasing a new car, choosing a vacation destination, studying for the bar exam. So should retirement. As a law professional, time can be of the essence. And while the short-term benefits of working on billable hours now may seem greater than the long-term benefits of saving for retirement, remember what you learned. The effort you put into planning your retirement today can positively impact your ability to live comfortably in retirement . . . even though your hyperbolic-discounting mind is telling you otherwise.

Christine Hotwagner

Christine Hotwagner is program operations director, ABA Retirement Funds. The ABA Retirement Funds, an affiliate of the ABA, is dedicated to helping lawyers with their retirement by providing fully bundled retirement solutions for law firms of all sizes. Established in 1963, the ABA Retirement Funds program has more than 3,800 plans, 38,000 participants, and more than $5 billion in assets. The information in this article is believed to be reliable. However, it is distributed with the understanding that the ABA Retirement Funds program is not engaged herein in rendering legal, tax, accounting, investment management, or other professional advice.