Asset Protection

Posted by & filed under Business Owners, Doctors, Healthcare, Legal.

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
Benefits
Tax deductible contributions
Highest level of asset protection (+5)
Tax-deferred growth Drawbacks
You must contribute to plan for all
eligible employees
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

post 10Your 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 “buckets” in which to grow wealth—and each bucket should be subject to a different tax treatment. Consider it a second, but equally important, diversification technique for your wealth—along with investment class diversification.
We spread our investments across different classes of investment so that, in the event some-thing bad happens impacting one industry, the total portfolio is not affected. With tax diversification, a similar theory applies. If you have some investments that may be taxed as ordinary income, some that may be taxed at capital gains or dividend tax rates, and some assets that may not be taxable at all, you have flexibility. When ordinary income tax rates are very high, you may choose to spend assets that are taxed at low capital gains tax rates or not taxed at all. When rates are low, you may choose to pay those taxes now. For example, some real estate investors in the last few years have NOT made 1031 exchanges. They volunteered to pay the 15% federal capital gains taxes. Others deferred the tax and may have to pay future federal rates of 20% or 28% when they sell (if rates increase). The goal is to have flexibility so you are never at the mercy of one legislative change. Some savvy investors exchange and later fund their charitable remainder trust with the replacement real estate in order to avoid the capital gains taxes.

How to Hedge Your Qualified Plan “Bet” with Tax Treatment Diversification
Above, we have recognized that, if history is any indication of the future, federal income tax rates may rise, perhaps significantly, in the future. We also understand that our qualified plans are, in fact, a bet on such future tax rates staying close to the rates today or decreasing in the future. Because such a bet is risky at best, we would all like to find a way to hedge against it. We can hedge against federal tax increases, using tax treatment diversification. Such diversification can be accomplished in two ways: (1) by accumulating non-qualified plan after-tax investments and (2) by using non-qualified benefit plans that are taxed differently from traditional qualified plans. Let’s examine each here:
1. Using After-Tax Investments
This technique is used by most doctors. It is simply investing one’s after tax savings in a liquid asset class (securities, savings, CDs, etc.) that can be accessed in retirement. Because these assets can be sold without significant income tax—stock sales will typically trigger “capital gains” taxes, while savings, bonds and CDs trigger income taxes on relatively small interest payments—they are much better protected against a high future income tax than qualified plan distributions that are 100% income taxable. In this way, if income tax rates are very high for a period of retirement, you could use these types of assets to live on and not draw down significantly on the qualified plan assets at that time. Even more importantly, by having this asset class as part of your retirement game plan, you are not as exposed to the risk of income tax rates increasing in the future.
While this technique is certainly crucial, it still has one tax risk—that capital gains tax rates rise significantly. In fact, while we call this technique “after tax investments,” this is actually a misnomer. That is because such assets will trigger capital gains taxes when they are sold and—for certain assets, like mutual funds—capital gains taxes are levied along the way as well.
Again, study the chart below. You will see that, at the time of publication, US federal capital gains tax rates are at the LOWEST point in the history of the tax. Putting politics aside, we do not think that it is unrealistic to expect that such rates will be higher at any point in the future. Again, does this mean that we should abandon this asset class? Absolutely not. However, it does make sense for most Doctors to examine a third tax asset class that can eliminate the risk of future income tax rate AND future capital gains tax rate increases.
2. Using Non-Qualified Benefit Plans
Non-qualified plans are relatively unknown to Doctors, despite the fact that most
Fortune 1000 companies make non-qualified plans available to their executives. This type of plan should be very attractive to Doctors, as employees are not required to participate AND allowable contributions for the owners and executives (Doctors, in the case of a medical practice) can be much higher than with qualified plans. Because there are numerous types of non-qualified plans—from split dollar plans to 162 Executive Bonus plans among many others—we will keep our discussion here to one type of plan that has both qualified and non-qualified traits and that can provide you with excellent tax diversification—the Group Term Life Plan authorized by tax code section 79, also known as a “Section 79 Plan.”
A Section 79 plan is a very flexible plan that has numerous benefits for a medical practice. As relevant here, the contributions are partially deductible and partially taxable at the outset—which is much better today than the “after tax investments” asset class and not as good as the qualified plan. The funds grow tax-deferred, which is the same as the qualified plan and better than the “after tax investments” class. Finally, in the future, when funds are accessed in retirement, they can be reached without tax—better than the “after-tax investments” and far superior to the qualified plan. In this way, the Section 79 plan avoids the risks of future income and capital gains tax rate increases in a substantial way—and can act as an ideal “hedge” against future income and capital gains tax increases.
In addition to playing the role as a future tax increase hedge, the Section 79 Plan has the following benefits:
· These plans can be utilized in addition to a qualified plan like pension, profit-sharing plan/401(k) or IRA.
· The funds in these plans can grow in the top (+5) asset protection environment in most states and always in a good (+2) environment at minimum, for states like California.
· In a group practice, not every doctor need contribute the same amounts—extremely beneficial for group practices with Doctors who want to “put away” differing amounts.
· The plan funding can be flexible.
· Employee participation requires a minimal funding outlay.
· There are no minimum age requirements for withdrawing income (no early withdrawal penalties).
· The transfer of assets at the Doctor’s death is income tax-free to heirs.

The Diagnosis
Most Doctors in the U.S. utilize some type of qualified retirement plan, including an IRA, as part of a benefit plan. Certainly, these types of plans can serve both as a protective (Fortress) and wealth accumulation (Engine) tool. On the other hand, too few Doctors use, or even investigate, non-qualified plans. This is unfortunate given the tax bet that qualified plans require—a bet that could be a losing one in the future. We hope that you make it a priority to hedge such a bet—and investigate other tax asset classes such as the plans described above.

Continue to Next Section