As an author of two books on financial planning specifically for physicians, we have had the opportunity to speak with hundreds, if not thousands, of doctors of various ages over the past decade. What we have seen is that two doctors of the same specialty with similar incomes can have very different income levels in retirement. Why? Three reasons physicians may have very different qualities of life in retirement are:
- Devastating Incident (lost lawsuit or divorce)
- Poor investments
- Lack of attention to taxes
Fortunately, both qualified retirement plans and fringe benefit plans can help you address the three challenges above in significant ways. Unfortunately, most physicians only utilize traditional qualified plans – such as pensions and 401(k)s – which are restrictive and burdensome, while completely ignoring the more flexible fringe benefit plans. In fact, only a handful of the thousands of the doctors we have spoken with over the years employ fringe benefit plans in a significant way. This is unfortunate.
In this article, we will discuss the basics of qualified and fringe benefit plans.
Qualified Plan Basics
The term “qualified” plan (“QP”) means that the plan meets the definition of a retirement plan under Department of Labor and Internal Revenue Service rules created under the Employee Retirement and Income Security Act (ERISA). These plans may be in the form of a defined benefit plan, profit sharing plan, money purchase plan, 40(k), or 403(b). Properly structured plans offer a variety of benefits: you can fully deduct contributions to a QP, funds within the QP grow tax-deferred, and (if non-owner employees participate) the funds within a QP enjoy superior asset protection. Despite the benefits QPs can offer, there are a host of disadvantages that physicians must understand:
- Mandated maximum annual contributions for defined contribution plans ($50,000 for pensions, profit-sharing plans, $17,000 employee deferral for 401(k) plans in 2012)
- Mandatory participation by employees
- Potential liability for management of employee funds in plan
- Controlled group and affiliated service group restrictions
- Penalties for withdrawal prior to age 59 1/2
- Required distributions beginning at age 70 1/2
- Full ordinary income taxation of distributions from the plan
- Full ordinary income taxation AND estate taxation of plan balances when you die (combined tax rates on these balances can be over 70%)
Despite these numerous disadvantages, nearly all physicians in the US participate in QPs. The tax deduction is such a strong lure, it often cannot be resisted. For some doctors, this makes sense. But for many, the cost of contributions for employees, potential liability for mismanagement of employee funds, and the ultimate tax costs on distributions to you and your family may outweigh the current tax savings offered by QPs.
This is especially true if you believe that income tax rates, especially the higher marginal rates, will go up over the coming decades. That is because, when you use a QP, you trade today’s tax rates on your contribution for the tax rates in the future when you pull the money out of the plan. If rates rise in the future, the QP might prove not to be a good deal at all. While none of us know what the future will bring, we do know that the highest marginal federal tax rates in the U.S. were well above 50% for most of the 20th century and that the highest rates today are the 3rd lowest they have ever been in the nearly 100-year history of the federal income tax. Thus, the QP tax rate bet is one that, at minimum, should be hedged against – which can be done with certain fringe benefit plans (see below).
SEP-IRAs are not officially QPs – they are custodial accounts, yet, in many ways, they are similar. You have the same tax restrictions on annual contribution amounts, penalties for early withdrawals, mandatory withdrawal rules, and taxation on distributions and plan balances at death as you have with a QP. One big difference is that a SEP-IRA may not enjoy the same level of asset protection that a QP does. The protection is not “federally mandated” but rather handled on a state by state basis. For these reasons, a SEP-IRA is typically no better financially than a QP.
Fringe benefit Plan Basics
Fringe benefit plans are, astonishingly, relatively unknown to physicians. This is true, despite the fact that most Fortune 1000 companies make fringe benefit plans available to their executives. While many of these plans in public companies cannot be used in a private medical practice (think stock options) many use structures that a physician certainly could easily employ in a practice.
Although fringe benefit plans are not subject to the qualified plan rules listed above, they are based on many of the same tenets. Some are explicitly compensation plans that provide some long-term retirement benefits and present tax reduction benefits to the key employee(s). Other plans are aimed primarily at a goal other than compensation, such as asset protection or employee retention.
EXAMPLE: FRINGE BENEFIT PLAN
Let’s examine one such fringe benefit plan that could be utilized by nearly all medical practices. It has been in the tax code for decades and the IRS issued ‘safe harbor’ rules related to the plan within the last decade. This makes the plan straightforward to implement properly from a tax point of view – just follow the rules already established.
Other benefits of the plan include:
- Utilization of the plan in addition to a qualified plan like pension, profit-sharing plan/401(k) or SEP IRA;
- Contributions qualify for current tax deductions;
- The plan assets grow tax-deferred and can be accessed tax-free;
- The plan acts an ideal “tax hedge” technique against future income AND capital gains tax increases • thus it can be used to “hedge” against the tax rate risk inherent in QPs described above
- Maximum contribution levels are $100,000 per doctor in practices with 10 employees or less. In larger practices, these levels can be even higher;
- In a group practice, not every doctor need contribute the same amounts • extremely beneficial for group practices who have doctors who want to “put away” differing amounts;
- 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
While these benefits are powerful, this plan is not for everyone. Like most plans, this benefit plan is only appropriate for physicians who are looking to build long term wealth. It is not one that is designed for contributions, growth and access in a short time frame.
Every successful physician should consider a fringe benefit plan. Qualified Plans are burdened with a host of restrictions, costs and tax limitations. This often makes them extremely expensive for the physicians and does not allow for significant retirement wealth accumulation. Fringe benefit plans do not have these restrictions and, therefore, are relatively inexpensive to implement. If building your retirement wealth is an important goal for your financial plan, we highly recommend you investigate fringe benefit plans in your practice.
SPECIAL OFFER: For a free (plus $5 S&H) copy of For Doctors Only: A Guide to Working Less and Building More, please call (877) 656-4362.
Carole Foos, CPA is a tax consultant at the national physician-focused consulting firm OJM Group. She can be reached at firstname.lastname@example.org or 877-656-4362.