Your Money: Are 401(k)s Overrated?

I’ve spoken to thousands of physicians over the past decade about financial planning, and one thing that’s become clear to me is that a physician’s level of retirement security is governed more by what he does with his income while he’s earning it than by the amount he earns. Indeed, I’ve seen countless situations in which two physicians in the same specialty and with roughly the same income face very different retirement prospects.

Why? Three reasons: 1) a devastating incident, such as a lost lawsuit or divorce, occurs; 2) the physician makes a poor investment; or 3) the physician doesn’t pay enough attention to the impact taxes can have.

The good news is that you can address all three of these potential scenarios using creative planning techniques, including qualified, nonqualified, and nontraditional retirement plans. The bad news is that most physicians sign up only for traditional qualified retirement plans, such as pensions and 401(k)s. These plans are restrictive and burdensome. Yet most physicians ignore the more flexible nonqualified deferred compensation (NQDC) plans available to them and to an even greater extent miss out on nontraditional benefit plans altogether. In fact, only a handful of the thousands of doctors I’ve spoken to over the years take advantage of NQDC or nontraditional plans.

That’s unfortunate.

Qualified plan basics

A “qualified” retirement plan, or QP, complies with federal rules created under the Employee Retirement Income Security Act of 1974 (ERISA). These plans may take the form of a defined benefit plan, a profit-sharing plan, a money-purchase plan, a 401(k), or a 403(b). Properly structured plans offer a variety of benefits: You can fully deduct your contributions to a QP from your income taxes, funds within the QP grow tax-deferred, and (if non-owner employees participate) the funds within a QP enjoy superior asset protection.

But there are also disadvantages, including:

• Maximum annual contributionsfor defined contribution plans ($41,000 for pensions and profit-sharing plans, $14,000 for 401(k) plans);

• Mandatory inclusion of all eligible employees;

• Potential liability for management of employee funds in the plan;

• Control group and affiliated service group restrictions;

• Penalties for withdrawal prior to age 59.5;

• Required distributions beginning at age 70.5;

• Full ordinary income taxation of distributions from the plan; and

• Estate taxationand full ordinary income taxation of plan balances when you die (combined tax rates on these balances can be more than 70 percent).

Despite these numerous disadvantages, nearly all physicians in the United States participate in QPs. The tax deduction is such a strong lure that few can resist it. For some doctors, this makes sense. But for many, the cost of contributions for employees, potential liability for mismanaging employee funds, and the ultimate tax costs on distributions to their families and themselves may outweigh the current tax savings offered by QPs. Tax- and business-savvy physicians may find asset-protected after-tax investments more valuable and flexible to their overall wealth protection plans.

SEP-IRAs

Simplified Employee Pension Plan IRAs, or SEP-IRAs, are not officially QPs; they are custodial accounts. But they are similar in many ways. They carry the same tax restrictions on annual contribution amounts, penalties for early withdrawals, mandatory withdrawal rules, and taxation on distributions and plan balances at death that exist with QPs. One big difference is that a SEP-IRA may not enjoy the same level of asset protection a QP does outside the context of bankruptcy. The protection in that case is not “federally mandated,” but rather handled on a state-by-state basis.

NQDC basics

Nonqualified plans are relatively unknown to physicians, even though most Fortune 1000 companies make nonqualified plans available to their executives. Many of these companies use plan structures you can easily employ in your own practice.

Although NQDC plans are not subject to plan regulations as ultra-onerous as those governing qualified plans, they are subject to some government rules. In fact, Congress recently passed legislation that further regulates NQDC plans. However, an NQDC plan is still an attractive option for many physicians when compared with a traditional qualified plan pension or SEP-IRA. The benefits include:

• More generous contribution limits;

• No mandatory participation by employees (you can choose who is offered participation and who is not);

• No control group and affiliated service group restrictions;

• No penalties for withdrawal prior to age 59.5; and

• No required distributions beginning at age 70.5.

One of the main drawbacks of NQDC plans is that the plan’s assets would be subject to the claims of your practice’s creditors. For this reason, many physicians in search of more flexible planning structures, as well as asset protection, look outside the qualified and nonqualified planning options to nontraditional plans that offer benefits for them in retirement.

Nontraditional executive benefit plans

As the term implies, nontraditional plans sit outside the regulations pertaining to qualified and NQDC plans. This way, options vary greatly in structure and can be tailored to meet physicians’ individual goals. In general, these plans have all the benefits of an NQDC plan. Plus, there are no mandated limits on annual contributions, and they can be structured to be both income tax- and estate tax-efficient.

Types of NT plans

With numerous NT plans available, I’ll list just a few of the most popular types:

• Compliant Split-Dollar Plans - Split-dollar plans have been the primary type of NT plan in the corporate workplace for the past 40 years. Split-dollar plans are life insurance plans whose value is shared between the company, or practice, and key employees - partner physicians, for example. Typically, the practice would pay the premiums and recover the cost, plus an IRS-determined rate of return, upon the death of the insured. The insured’s beneficiaries would receive the rest.

Recently, however, the IRS has changed the rules significantly regarding split-dollar plans. Unfortunately, many advisers who do not practice much in this area are under the misconception that split-dollar plans are now “dead.” Nothing could be further from the truth. In fact, the essential change was to set a predetermined rate of return to the company (or practice).

Although it is certainly more difficult to implement a split-dollar plan for public companies under the new rules, such plans can still be a viable option for private businesses, including medical practices. In fact, with interest rates relatively low, this may be the perfect time for a medical practice to adopt a split-dollar plan.

Physicians can take advantage of this structure and enjoy significant retirement wealth accumulation without offering it to any employees. These types of plans can be structured to handle many of the buyout/buy-in issues between the younger and older partners within a practice. If you would like to investigate the possibility of having more income in retirement and explore tax-efficient ways to ease the transition of practice ownership, I highly recommend you consider the advantages and disadvantages of a compliant split-dollar NT plan.

• Asset Protection NT Plans - In many circumstances, the central goal of an NT plan may be to protect a practice’s assets. Have you ever been concerned that one partner’s mistake could catalyze a lawsuit that would decimate all of your practice’s real estate, equipment, and accounts receivable? If so, you may be delighted to hear about a solution that can also offer retirement and tax benefits.

Most popular in this arena for physicians are plans that protect a practice’s A/R. However, in this type of NT plan, it is crucial to properly negotiate both asset protection and tax issues. In most of the plans that I have reviewed, common pitfalls lurk. Be careful.

• Financed NT Plans - When properly structured, these plans can provide the greatest after-tax investment return to participating physicians. Because an outside lender puts up the initial capital to fund the plan but takes back a fixed return, the physicians benefit from using “OPM” - other people’s money - compounded on a tax-deferred basis. Further, the plans are typically structured for substantial asset protection against the creditors of both the medical practice and individual physicians.

Every successful physician should consider an NQDC and/or nontraditional plan. Qualified plans are burdened with a host of restrictions, costs, and tax limitations that often make them expensive for physicians and reduce significant retirement wealth accumulation. NQDC plans have much fewer restrictions and therefore can be relatively inexpensive to implement. NT plans are the most flexible, provide asset protection, and can most likely offer the best return to physician participants.

David B. Mandell, JD, MBA, is an attorney, lecturer, and author of “Wealth Protection, MD.” He is also a cofounder of the Wealth Protection Alliance (WPA), a nationwide network of independent financial advisory firms whose goal is to help clients build and preserve their wealth. He can be reached at 800 554 7233, or via editor@physicianspractice.com.
This article originally appeared in the September 2006 issue of Physicians Practice.