By Mark Papalia, CLU
You’ve worked hard to build your practice into what it is today. If you’re like most professionals, your practice is one of your greatest assets and you are paying steep taxes each year on the revenue your practice generates. Isn’t it time you save some of those taxes and turn the value of your practice into a more usable retirement asset?
Leveraging Your Practice’s Value
It’s not practical to simply work hard until you’re 60 and expect that someone will come to you, ready to buy out your practice and fund your retirement. Rather, you need to build your retirement assets and plan your exit strategy, well in advance of your senior years. Many physicians are realizing that they can create a healthy nest egg during their 40s and 50s, by borrowing against the value of their practice and using the loan proceeds to fund a supplemental retirement program.
The first step is to determine how much of a loan you can get against the value of your practice. A professional practice is typically valued based on the income that the practice produces, and the anticipated revenue it would produce if it were sold or transferred to another professional. However, a bank will not consider this full value as collateral for a loan; generally a bank will only let you borrow the equivalent of your hard assets when making a loan. For most physicians, their greatest hard asset is their accounts receivable.
The next step is to turn a loan into an asset that pays you a greater return than the loan repayments are costing you. Let’s look at an example. Suppose your practice is appraised at a value of $2 million and you have about $500,000 in receivables. In this instance, a bank might make a loan of about 75 percent of your receivables, or $375,000. However, if you tell the bank that you are going to use part of the loan proceeds to fund an insurance product and will provide that policy as collateral for the loan, a bank might loan you an amount nearing 50 to 75 percent of your practice’s full value, or $1 to 1.5 million.
You then have your practice repay the loan to the bank. The loan interest is then tax deductible as a business expense. Ideally, you begin accumulating earnings on your investment of the loan proceeds at the same time, at a higher rate than the prevailing interest rates you are paying. Depending on the tax structure of your practice, this strategy enables you to use your practice’s value to build personal wealth for your future.
Be aware that this strategy works better, the longer you have until retirement. The longer you have to accumulate earnings on your investments, the more leverage you have. Therefore, this strategy is better suited to physicians under age 50 who have considerably more time until their planned retirement date.
Maximizing Your Qualified Retirement Plans
In our firm’s experience, one of the best ways for physicians to accumulate transferable wealth is through the use of qualified retirement plans. There have been several favorable law changes over the past few years that offer physicians more opportunities to turn their practice revenue into personal wealth.
Probably the most commonly known retirement program is the 401(k) plan. In the past, 401(k) contributions significantly limited the amount the business owner could contribute to his/her own 401(k) account. Under new law this is no longer the case; presently, most professional practice or business owners can maximize their 401(k) and other plan contributions (to put away the maximum contribution for themselves which in 2004 will be $41,000), while contributing as little as five percent of pay for their other employees. This does, however, vary and is contingent upon employee demographics. Physicians who are age 50 or older can take advantage of a newly created “catch-up contributions” provision in the law that allows them to contribute an extra $3,000 to their retirement plans in 2004.
Another plan design deserving consideration is a defined benefit plan. In contrast to a 401(k), defined benefit contributions are not limited to $41,000. Instead, the law requires an employer to contribute whatever amount is necessary to create and fund a trust that is held over time and pays for stated benefits that are paid out to participants in the future. Each year, an actuary looks at the trust and calculates the contribution levels necessary to keep the trust growing at a rate that will ultimately fund the defined benefit. Since the employer is required to contribute the amount required each year to fund the final benefit, all contributions are fully tax deductible.
However, the Internal Revenue Code (IRC) includes limitations on allowable deductions for qualified plan contributions. In a 401(k) plan, you can only deduct a total of 25 percent of participant payroll. In a defined benefit plan, you can deduct all of your annual contributions because that is what is required to keep the benefits funded. The tax act signed into law by President Bush in 2001 created opportunities for physicians to sponsor both a 401(k) plan and a defined benefit plan. Even though there are special rules relating to combined plan sponsorship, combined plans allow for maximum deductions and provide for an even greater accumulation of transferable wealth.
One form of a defined benefit plan rapidly gaining popularity is a Section 412(i) plan, which is funded exclusively through the purchase of life insurance, annuity contracts or a combination of the two. As with any defined benefit plan, an employer’s contributions are tax deductible and taxes on investment growth are deferred until the physician begins to withdrawal from the plan. Differing from traditional defined benefit plans, a 412(i) plan does not require an actuary to calculate annual contribution requirements. Instead, the required annual contribution is equal to the premiums due on the insurance and/or annuity contracts held within the plan. The physician sponsoring a 412(i) plan faces minimal risk to principal since the insurance carrier issuing the contracts guarantees the benefits assuming, of course, all premiums are paid when required.
Since a 412(i) plan does not require an actuary to perform services, these plans are generally less expensive to administer than other defined benefit plans. While 412(i) plans are an attractive option for physicians of all ages, generally, they become even more appealing to physicians over the age of 50 who wish to ensure minimal risk to principal. These plans need to be considered and administered carefully to maintain their qualified status. Several 412(i) providers have stretched the current regulations to sell insurance policies in excess of legal limits. As with all important decisions, great care should be exercised when selecting a qualified consultant to help you through the maze of choices you are faced with. Like a quality physician, your plan consultant should focus first on understanding your particular situation, help you understand the options best suited to meet your needs and aid you in successfully completing the course of action chosen.
Another option for physicians looking to maximize their practice revenue is to set up a Voluntary Employees Beneficiary Association (VEBA), which is a welfare benefit plan as established under IRC Section 501(c)(9). Physicians can make large tax-deductible contributions to a VEBA. Plan assets accumulate tax-deferred and are protected from creditors. Survivor benefits are income tax free and may even be passed on to heirs, estate tax free. In addition, contributions to a VEBA do not reduce allowable contributions to a qualified plan. A VEBA enables physicians to fund their future medical benefits, disability, life insurance, long-term care needs and other similar benefits on a tax-favored basis.
Who should consider a VEBA? Physicians looking to supplement or enhance their business-succession plans or desiring to reduce, eliminate or provide liquidity for estate taxes often garner value from a VEBA. For example, using the death benefit in the VEBA is a more tax-efficient method of providing cash to beneficiaries. Additionally, those wishing to protect their assets from creditors, which can be especially attractive to physicians who have high-liability practices, should consider sponsoring a VEBA.
You’ve worked hard to build your practice and it is most likely time to put your practice to work for you. You can build personal wealth and reach your retirement goals, if you plan proactively and carefully.
Mark Papalia, CLU, ChFC, CFP, is president and founder of Papalia Financial in Danville, Pa.