Using Qualified & Non-Qualified Plans
This section discusses two topics which are related and can contribute to the practice being both a Fortress and an Engine. However, the article is unique in that almost every Doctor takes advantage of the first option—qualified plans—while almost none utilize non-qualified plans. We will discuss both popular qualified retirement plans and less common non-qualified plans here, so that you can be aware of options that are available to you and, hopefully, get more out of your hard work, build greater wealth and enjoy the fruits of your labor.
Use Qualified Retirement Plans
A “qualified” retirement plan describes retirement plans that comply with certain Department of Labor and Internal Revenue Service rules. You might know such plans by their specific type, including pension plans, profit sharing plans, money purchase plans, 401(k)s or 403(b)s. Properly structured plans offer a variety of real economic benefits, such as:
· The ability to fully deduct contributions to these plans.
· Funds within these plans grow tax-deferred.
· Funds within these plans are protected from creditors.
In fact, these benefits are likely the reasons why most medical practices sponsor such plans.
For this chapter, we will include IRAs as “qualified plans” even though, technically, they are not. We are doing this because IRAs have essentially the same tax rules as qualified plans and have the same attractions to Doctors who can use them.
As you will learn in Lesson #6 on asset protection, qualified plans and IRAs enjoy (+5) protection in bankruptcy—for asset protection purposes.
You can learn more about their tax benefits (and drawbacks) in Lesson #7. You will see that the obvious tax benefits may be outweighed by the less obvious tax drawbacks.
With qualified plans (not IRAs), they must be offered to all “qualified” employees (within certain restrictions). For a Doctor owner, there may be some economic costs to having a plan which you must offer to, and contribute for, everyone at the office or at related businesses. With these mixed benefits and drawbacks, it is surprising how many Doctors (nearly 100%) use qualified plans and ignore their cousins, non-qualified plans, which are far less restrictive. Review the following chart so you can better understand the pros and cons of qualified plans.
Benefits & Drawbacks of Qualified Plans
Tax deductible contributions
Highest level of asset protection (+5)
Tax-deferred growth Drawbacks
You must contribute to plan for all
All withdrawals subject to ordinary income tax rates
Penalties for access prior to age 59
Must take minimum distributions at age 70
May be taxed at 75% or more at death
Your Qualified Plan “Bet” on Future Tax Rates
In other parts of the book, we cover most of the benefits and drawbacks of qualified plans in more detail. Here, we want to make sure you understand the bet you are making on future tax rates when you rely on qualified plans heavily for your retirement. Since all amounts that come out of qualified plans (and SEP and roll-over IRAs, of course) are 100% income taxable, there is no way to know how good (or bad) a financial deal such a plan could be for you until you know the tax rates when you withdraw funds.
In other words, if you contribute funds to a qualified plan today (when the top federal income tax rate is 35%) and withdraw funds when income tax rates are at the same or a lower level, the deduction today and tax-free growth over time is likely a “pretty good deal” for you. However, if you withdraw funds from your plan and the top federal tax rates are 40%-50% or higher, then the qualified plan/IRA may be a “bad deal” for you. Certainly, future federal income tax rates of 50% or more could make qualified plans a very negative long term investment proposition for you.
[Clarification Point: Some folks may argue that, in retirement, doctors are likely to have less income and thus the plan distributions will be taxed at lower rates. While this may be likely for 95% of taxpayers, many doctors will build enough wealth in retirement and non-retirement assets to be in the top marginal tax rates in retirement. The second highest marginal income tax rate (2% less than the highest rate) goes into effect when a married couple earns TOTAL income of only $200,300 in 2008. If you are single, divorced or widowed, that second highest rate applies to income above $164,550. Do you think that your total income will be less than $164k or $200k when you add in retirement distributions, Social Security, rental income, and any investment gains from non-pension assets? In many cases, doctors are going to retire only when their retirement assets will generate incomes equal to their last year’s salary. For most of our clients, this is the retirement game plan—retire only when they can maintain the lifestyle to which they have become accustomed]
With this is mind, review the history of US income tax rates chart below. Putting aside politics, you must understand that it is certainly a possibility that tax rates can return to the levels they were for most of the 20th century. If they do, qualified plans utilized today by most doctors may turn out to be “losing bets” in the long run. Since we cannot know what future tax rates will be, we need to at least acknowledge the bet we are making and ask how we can reduce our risk and perhaps hedge against such a losing bet.
A New Concept for Investing—Tax Treatment Diversification
Does the fact that our qualified plans today may turn out to be losing bets mean that we should abandon them? In most cases, the answer is “no.” These plans generally have the strongest asset protection available and provide significant incentives for employees. We would strongly recommend, however, that EVERY doctor make investments that offer a hedge against potential tax rate increases.
The concept here is that you should have various More