For most doctors an "off the rack" plan from an accounting, legal, insurance or investment firm just doesn't work.
By David B. Mandell, JD, MBA
For most doctors an “off the rack” plan from an accounting, legal, insurance or investment firm just doesn’t work. These plans have been created because they can be replicated millions and millions of times for the “average American.” According to the U.S. Census Bureau, the average American family earns less than $49,000.
With that in mind, most legal, accounting, insurance and investment strategies have been created for:
1. The average American family whose annual income tax liability is less than 12%.
2. The 98% of American families who will NEVER owe any estate taxes.
3. An employee, not an employer, who will likely never be sued and who has no control over the choice of legal entity or type of retirement vehicles the employer will utilize.
4. Someone whose income is based on productivity, NOT government regulation.
For most doctors, most, if not all, of these characteristics are not true.
The media and publishers are also geared toward the average American. In general, they fear that providing content generated for few high-income readers will alienate their average readers and the advertisers who pay good money to reach a specific audience.
Practically, what this means for physicians is that financial and legal advice you get from print and online media, and from large national firms is most likely not appropriate for physicians.
Doctors who follow advice that is generated for the masses and doesn’t take into consideration their unique challenges should see themselves as the patient who focuses on the results of his own 10-minute internet search over the specialist’s educated diagnosis based on decades of experience and the results of a personal exam and test results.
There is no profession with as large a set of unique challenges as physicians face. For this reason, it is imperative that doctors look for advisers who spend the majority of their time working with physicians.
To take it a step further, if you are a high liability or high income specialist, you will want to work with a team of advisers that is acutely aware of these additional challenges. For example, an obstetrician has a much greater need for asset protection than a pediatrician, and a surgery center owner has much greater tax challenges than a primary care doctor.
Conventional wisdom is not your friend
Solutions that are widely-accepted in the media and by advisers generally work for the average taxpayer. One hurdle that advisers who specialize in helping high-income doctors face is the fact that the solutions we (as a group) espouse are appropriate for less than 1% of the families in the country.
For that reason, doctors who insist on only implementing strategies they have heard over and over again in the media and from their colleagues will miss out on valuable opportunities. Once you embrace the fact that you are different and require “different” planning than your neighbors, you will have taken one very significant step to significantly improving your financial situation.
Here are a few examples of mistakes physicians make when listening to bad, but common, advice.
“You don’t need a corporation for your medical practice”
Despite what your CPA may say, in most cases the cost and aggravation of creating and maintaining a corporation (or in many cases, two corporations for most medical practices) are insignificant relative to the asset protection and tax benefits corporations offers physicians.
With recent tax law changes and with many new proposals we will see over the next year, the benefits will be compounded. These corporate solutions can reduce taxes by $5,000 to $50,000 per year for the doctor.
Owning anything in your name, spouse’s name or jointly
We acknowledge that owning assets in your own name or jointly with a spouse are the most common ownership structures for real estate and bank accounts. This is okay for 95% of Americans. Hopefully, by now, you realize that you are not in that common group.
You have potential lawsuit risk, probate fee liability, and estate tax risks that over 95% of the population does not have. If you don’t want to unnecessarily lose assets to lawsuits or taxes or accidentally disinherit children, you need to consider alternative ownership structures.
Something as simple as a living trust or a limited liability company can often solve these problems.
Wasting time and money on Qualified Retirement Plans
This is perhaps the single most important area of planning for doctors to address once they understand that they are different.
Typical retirement plans are great for rank-and-file employees because they force employees to put away funds for retirement. Employers may match some percentage of employee contributions (which is free money for the employee). The investment grows tax-free until funds are accessed in retirement (when the employee is living on modest Social Security and these retirement plan funds).
As “the employer,” there is no “free money” for you as all the money that ends up in your plan account was yours to begin with. In fact, you are responsible for those matching contributions so the retirement plan does have some “friction” for you if you want to make any reasonable contribution on your own behalf.
On top of that, you will not be living on $25,000 to $50,000 in retirement like your employees will. You will have taxable investments, much larger retirement plan contributions and greater Social Security income (maybe).
In any case, you will be paying very significant tax on your retirement plan withdrawals. Do you think that tax rates will be lower than they are now when you retire?
With rising costs for employees and a possibility that you may actually withdraw funds from your retirement plans at a higher tax rate than the one you received for the original deduction, the real benefit of retirement plans comes into question.
When you add the potential costs and aggravation of complying with ERISA, Department of Labor and tax laws surrounding retirement plans, and the fact that any unused retirement plan balances will be taxed at rates up to 80%, you may find that retirement plans are not all they are cracked up to be.
A growing trend among successful doctors is to implement non-qualified planning alternatives instead of traditional retirement plans.
Non-traditional planning can offer higher income physicians opportunities to contribute significantly larger annual contributions. Whether you are using non-qualified plans, “hybrid” plans, fringe benefit plans or even a tool primarily designed for risk management benefits, like a captive insurance company, you could potentially enjoy tax benefits up to $100,000 to $1,000,000 or more annually.
Most of these tools allow you access to the funds before 59-and-a-half, will not force you to take withdrawals at age 70-and-a-half if you don’t need the money and will not be taxed at rates up to 70% or 80% when you pass away. For these reasons, savvy doctors utilize nontraditional plans more than traditional retirement plans.
Of course, non-qualified or “hybrid” plans vary significantly in their design, their scope and their applicability. Some plans work great for smaller practices with one or two partners. Others work best in practices with three to 20 partners. Still others may work best for the larger practices.
Don't pay full price when the government offers to pay half
Technically, the government (Internal Revenue Service) is not paying half of anything. However, if it offers you a tax deduction and your combined state, federal and local marginal tax rate is close to 50%, you can think of a tax-deductible purchase as being half as expensive for you the government will allow you to deduct this purchase.
You must realize that nearly 50% of Americans do not pay any federal income tax, according to the IRS. In 2009, Exxon boasted $45 billion of profit to its shareholders — with $0 of U.S. income taxes paid. You can either look to advisers who can help you legally reduce any unnecessary taxes or you can let the system work for everyone else but you. Let’s look at an example of one simple way to use tax laws to your benefit.
Physicians can deduct Long Term Care insurance (LTCi) through their practices. Over 60% of American households will require some sort of Long Term Care assistance. Doctors, more than any other segment of the population, realize that longer life expectancies and skyrocketing medical costs significantly increase the probability of a family facing an illness with devastating financial consequences.
Without a shifting of risk through a long term care insurance policy, you will have to pay for this assistance from your savings. You can cover your spouse through the practice even if you both are not physicians or employees. If you are a C corporation, you may receive a tax deduction for 100% of the premiums and can pay all of the premiums over a 10-year period to take advantage of the deductions during your prime earning years (when the deductions are most valuable).
By paying premiums over a short period of time, you will ensure that you will not have unexpected expenses for this insurance once in retirement. Unlike traditional retirement plans where contributions are tax-deductible and benefits are taxable, Long Term Care insurance premiums can be tax-deductible and the benefits are 100% tax-free.
There are also non-traditional benefit plans that also allow physicians to make contributions of $100,000 or more per year, discriminate to only include the doctors or key employees, and access the funds before age 59-and-a-half without penalty. These plans can be set up to be very important pieces of a family’s estate plan without sacrificing tax deductions or control of the assets by the doctor.
Stop wasting money on taxes and term insurance premiums
A famous female financial adviser with her own TV show is one of many advisers to tout, “Buy term insurance and invest the difference.” This is excellent advice for the “Average American” family that earns $49,000 per year, pays 12% in federal income taxes and has no potential liability or estate tax risk whatsoever. This is a perfect example of good advice for most people being terrible advice for high-income specialists.
Most Americans pay very little tax on investment income and don’t care about asset protection, so the advice to disregard the tax-free accumulation and creditor protection benefits of cash value life insurance to maximize taxable investment accounts is fine … for those people.
Beyond temporary income protection against the premature death of the breadwinner, the Average American has little need for cash value life insurance. This advice is good if you have the following characteristics:
1. No concern over lawsuits against me, my partners, my employees or my family.
2. Not worried about 23% to 47% of my investment income going to taxes.
3. Don’t mind 40%-70% of certain assets in my estate going to taxes when I die.
Does this sound like the typical physician situation? Of course, it doesn’t. These completely different characteristics clearly illustrate how “off the rack” planning that is widely accepted by the media and the general population may not adequately help doctors address their unique challenges.
Physicians should buy cash value life insurance for tax-savings and asset protection. If you are skeptical of this advice, ask yourself whether you are skeptical because you did the calculations yourself (or reviewed a careful analysis by an expert) or because you have heard, “Buy term insurance and invest the difference” so many times that you have just accepted it as fact.
Let’s look at it more closely:
1. Mutual funds growing at 8% (taxable) are worth 5% to 6% (after taxes) to high-income taxpayers like you and worth 7% or more to Average Americans.
2. Investment gains within cash value life insurance policies are tax deferred and can be accessed tax-free.
3. For relatively healthy insureds, the annualized cost of all internal expenses within a life insurance policy range from 1% to 1.5%.
4. For families in high marginal tax brackets, the cost of the insurance policy is less than the cost of taxes on the same investment gains within mutual funds.
Without even factoring in the cost of the term insurance (which would reduce the total amount in the mutual fund portfolio), the cash value insurance investment outperforms buying term insurance and investing the difference. Yet another benefit is that life insurance is protected from creditors, and even from bankruptcy creditors, in many states. This is a benefit that may interest a physician family, but be seen as worthless to Average American families who have no real financial threat of a lawsuit.
Consider a 45-year-old healthy male who wants to invest $25,000 per year for 15 years before retirement and then withdraw funds from ages 61 to 90. Assume this individual’s tax rate on investments is 31% (50% from long-term gains and dividends, 50% from short term gains, plus 6% state tax). Assume the gross pretax return of both taxable mutual fund investments and cash value life insurance are 8% per year.
The individual who invests in mutual funds on a taxable basis will be able to withdraw $36,940 per year after taxes (without factoring in the costs of purchasing ANY term life insurance or the cost of creating legal structures for asset protection — which a doctor may need to do to protect assets from lawsuits).
The individual who invests in cash value life insurance withdraws $47,080 per year (no taxes on policy withdrawals of basis and loans) and has $511,833 of life insurance protection.
In the example above, it is obvious that buying term and investing the difference in taxable investments was not better than investing in tax-efficient life insurance for a highly compensated physician in a high tax bracket.
David Mandell, JD, MBA, is a principal of the financial consulting firm OJM Group.
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This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized legal or tax advice. There is no guarantee that the views and opinions expressed in this article will be appropriate for your particular circumstances. Tax law changes frequently, accordingly information presented herein is subject to change without notice. You should seek professional tax and legal advice before implementing any strategy discussed herein.