By Christopher R. Jarvis, MBA and David B. Mandell, JD, MBA
According to the US Census Bureau, the average American family earns less than $49,000. To become a large national firm in the fields of law, accounting, investments and insurance, you MUST deliver services, products and strategies that can be replicated millions and millions of times. Before you can understand why MOST strategies and services are bad for doctors, you must understand the dynamic of the “Average American,” for whom these products and services are ideally meant to benefit from them.
Most legal, accounting, insurance and investment strategies have been created for:
- The average American family whose annual income tax liability is less than 12%.
- The 98% of American families who will NEVER owe any estate taxes.
- 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.
- Someone whose income is based on productivity, NOT government regulation.
If the four statements above sound like your life, then “Off the rack” planning at most firms is likely sufficient for your needs. For most doctors, most if not all of these characteristics are not true.
As authors of books and articles, we regularly interact with publishers, editors and talk show hosts. Radio and television stations, book & magazine publishers, and internet content editors are looking for content for their “average” reader. 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: 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 advisors 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 advisors who are 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.
In the beginning of the article, we pointed out what characteristics are common for US taxpayers. Solutions that are widely-accepted in the media and by advisors are generally tools that work for these people. One hurdle that advisors 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.
In the rest of this article, and in Part 2 of this article (which will be published next month) will share a few examples of common mistakes physicians make when listening to bad, but common, advice. These include:
Mistake #1 – “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. Though these corporate solutions can reduce taxes by $5,000 to $50,000 per year for the doctor, these particular strategies are outside the scope of this two-part article.
Mistake #2 –Owning Anything in Your Name, Spouse’s Name of Jointly with Your Spouse! 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 do 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.
Mistake #3 – 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 then 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.
Suggestion: Use a BETTER Retirement Plan to Support Your Retirement. Non-traditional planning can offer higher income physicians opportunities to contribute significantly larger annual contributions. Whether you are using non-qualified plans, “hybrid” plans, or even a tool primarily designed for risk management benefits, like a captive insurance company, you could possibly deduct $100,000 to $1,000,000 or more annually. Most of these tools allow you access to the funds before 59½, will not force you to take withdrawals at age 70½ 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.
Note: 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 3 to 20 partners. Still others may work best for the larger practices.
Risk #4 – Paying Full Price when the Government Offers to Pay Half. Technically, the government (Internal Revenue Service) is not paying half of anything. However, if they offer 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 ½ as expensive for you because the government will allow you to deduct this purchase. You must realize that nearly 50% of Americans do not pay any federal income tax (Source: IRS). In 2009, Exxon boasted $45 billion of profit to its shareholders – with $0 of US income taxes paid. You can either look to advisors who can help you legally reduce any unnecessary taxes or you can let the system for everyone else but you. Let’s look at an example of one simple way to use tax laws to your benefit.
Suggestion – Deduct Long Term Care insurance (LTCi) through your Practice. 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 are not both 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 that 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 59½ 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. For further information on these plans that are beyond the scope of this article, please contact the authors at (877) 656-4362 or Mandell@ojmgroup.com.
Mistake #5 – Wasting Money on Taxes and Term Insurance Premiums. A famous female financial advisor with her own TV show is one of many advisors to tout, “Buy term insurance and invest the difference.” This is excellent advice for the “Average American” family who 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. If you have the following characteristics:
- I have no concern over lawsuits against me, my partners, my employees or my family.
- I am not worried about 23% to 47% of my investment income going to taxes.
- I 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.
Suggestion – 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.
In our firm, we have advisors with MBAs in finance, CPAs, CFPs, and other financially-savvy experts. To spare you the pain of a long mathematical proof, let us offer the following simplified analysis.
- Mutual funds growing at 8% (taxable) are worth 5%-6% (after taxes) to high income taxpayers like you and worth 7% or more to Average Americans.
- Investment gains within cash value life insurance policies are not taxed.
- For relatively healthy insureds, the annualized cost of all internal expenses within a life insurance policy range from 1% to 1.5%.
- 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.
EXAMPLE: 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 $37,000 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 $42,500 per year (no taxes on policy withdrawals and loans) and has $1,000,000 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 an attorney, lecturer, and author of five books for physicians. Christopher Jarvis is an MBA with over 15 years of consulting experience. They are both principals of the financial consulting firm O’Dell Jarvis Mandell LLC. This article contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment or tax advice. You should seek professional tax and legal advice before implementing any strategy discussed herein. The authors welcome your questions. You can contact them at (877) 656-4362 or through their website www.ojmgroup.com.
I do not agree with most of what the authors are saying. It would seem that the only products these authors offer are the ones that they are promoting. Also there are some inconsistencies in this article around cash value insurance and qualified retirement plans that I can further expand upon if people would like me to. These products have been proven to be very expensive and primarily benefit the agents selling them and should only be utilized AFTER exhausting all other tax advantages (401k, Back door Roth, HSAs, 529s, etc.) and after setting up taxable investment accounts (gains are taxed at the lower capital gains rate rather than ordinary income rates).
Being married to a physician (OB-GYN) and having a sibling, father, aunts and uncles as well as many friends as physicians, I know that many physicians can be naive when it comes to managing their money and running their practice as a small business. But you need to do the basics first, before getting into the more expensive financial engineering that may not have the payoff since much of it is eaten up by fees and expenses.
Many times conventional wisdom is your friend.
I believe this is a very well put together article. Statement that ” These products have been proven to be very expensive and primarily benefit the agents selling them and should only be utilized…” is true fro some companies but definitely not true for all. Funding a 401k, back dooring a Roth and using an HSA is normally not enough savings for people that this article is speaking to.
There are many studies being done now that show that a retirement plan with a mixture of investments, cash value insurance and income streams, have a higher probability of succeeding. Yes some companies have high fees and are expensive, but again this isn’t true for all. And there is enough FACTUAL data to show that these products can be a great compliment, not competition, to your traditional investments. This is the same with anything else, you can’t trash all restaurants just because you had a bad experience, all of them aren’t the same.