Use nonqualified plans with cash value life insurance to achieve retirement goals
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Key takeaways:
- A benefit of nonqualified plans is the flexibility they offer in terms of participation.
- In many states, cash value life insurance policies provide robust asset protection against creditors.
Nonqualified plans offer a valuable alternative or supplement to qualified retirement plans for physicians seeking to enhance their retirement savings.
Unlike qualified retirement plans (QRPs), such as a 401k and profit-sharing plans, nonqualified plans are not bound by Employee Retirement Income Security Act (ERISA) guidelines, allowing for greater flexibility and potential benefits. Among the various funding options for nonqualified plans, cash value life insurance stands out due to its tax advantages and asset protection features.
This article explores the benefits of using cash value life insurance in nonqualified plans and presents three case examples to illustrate its effectiveness.
Advantages
The advantages of nonqualified plans with cash value life insurance include:
- No contribution limits. One of the primary advantages of nonqualified plans is the absence of contribution limits. Unlike QRPs, which impose strict annual contribution limits, nonqualified plans allow physicians to contribute as much as they desire.
- Tax-free growth and withdrawals. Nonqualified plans utilizing cash value life insurance offer significant tax benefits. Contributions to these plans grow tax-deferred, meaning the investment gains within the life insurance policy are not subject to annual taxation. Moreover, if managed correctly, withdrawals from the policy can be accessed tax-free. This dual tax advantage — tax-deferred growth and tax-free withdrawals — enhances the overall return on investment and provides a more efficient way to save for retirement.
- Flexibility in participation. Another key benefit of nonqualified plans is the flexibility they offer in terms of participation. QRPs often require mandatory participation from all eligible employees, creating a one-size-fits-all approach. In contrast, nonqualified plans allow physicians to choose whether to participate, determine their contribution levels and select the specific funding vehicles that best suit their financial goals.
- Asset protection. In many states, cash value life insurance policies provide robust asset protection against creditors. This means that the funds accumulated within the policy are safeguarded in the event of a lawsuit or bankruptcy.
How to establish
Creating a nonqualified plan involves several steps, each designed to ensure that the plan aligns with the physician's financial goals and offers maximum benefits:
- Planning and modeling. The first step in establishing a nonqualified plan is comprehensive planning and modeling. Physicians must design their plan based on their individual financial goals, risk tolerance and retirement timeline. This involves choosing the type of cash value life insurance policy (such as whole life or equity-indexed universal life), determining the contribution levels and setting a distribution schedule.
- Agreement and funding. Once the plan is designed, a formal agreement is established between the employer and the employee. This agreement outlines the roles and responsibilities of both parties, detailing the fees associated with the plan, how contributions will be handled and the terms of participation. Funding the nonqualified plan involves making contributions according to the physician's chosen schedule. Contributions are typically made directly from the physician's compensation, similar to a forced savings mechanism.
- Regular reviews. Regular reviews are essential to ensure that the nonqualified plan performs as expected. Physicians should conduct annual reviews with their financial advisors to assess the policy's performance, make necessary adjustments and stay aligned with their retirement goals. These reviews help identify any potential issues early and allow for proactive management of the plan.
Case studies
For illustrative purposes, we chose physicians of different ages, participation levels, genders and investment risk tolerances to demonstrate how a nonqualified plan can be beneficial for a range of physicians. For each physician, we show a comparison of the nonqualified plan to the type of investment they already had in place, including the income each option would generate for retirement, specifically from ages 65 to 84 years.
For their portfolios, we assumed each physician pays his or her investment advisor 100 basis points (bps) (1%), and that their underlying funds have a 50-bps fee and generate about a 1% tax drag. We also assumed the following tax rates on withdrawals: 37% federal tax rate, 5% state tax rate and 3.5% Affordable Care Act tax. For their policy in the nonqualified plan, we looked only at high-rated carrier products.
Case #1: Dr. John Smith, 52-year-old cardiologist: Dr. Smith, a conservative investor, decided to contribute $100,000 annually for 10 years to a nonqualified plan funded with a whole life insurance policy. Without the plan, he would have invested in a conservative portfolio expecting a 6% annual return. With a whole life policy yielding a 5.75% dividend rate, Dr. Smith's policy generated $94,285 annually in retirement, an 11% improvement over the $83,668 from his conservative portfolio. Over 20 years, this translated to an additional $212,000.
Dr. Smith valued the stability and predictability of the whole life policy, knowing that his contributions would grow steadily and provide a reliable source of income in retirement. The tax-free nature of the policy's growth and withdrawals further enhanced his retirement security, making the nonqualified plan a crucial part of his overall financial strategy.
Case #2: Dr. Jane Doe, 47-year-old surgeon: Dr. Doe opted for an equity-indexed universal life (EIUL) policy with a floor of 1% and a cap of 9.25%, assuming a 6% annual return. Contributing $50,000 annually for 10 years, her EIUL policy generated $83,496 annually in retirement, a 45% improvement over the $57,515 from her balanced portfolio expecting a 7% annual return. This resulted in a total gain of $519,627 over 20 years.
Dr. Doe was attracted to the EIUL policy because of its potential for higher returns linked to the performance of the S&P 500 stock index. The policy’s downside protection, ensuring that her returns would not fall below 1%, provided peace of mind against market volatility. This combination of growth potential and protection made the EIUL policy an ideal choice for her nonqualified plan.
Case #3: Dr. Michael Brown, 35-year-old general practitioner: As a young and aggressive investor, Dr. Brown chose an EIUL policy like Dr. Doe's and took advantage of the option that has a 10.25% cap with 0% floor. Contributing $25,000 annually for 10 years, he compared this to an aggressive stock-based portfolio with an 8% expected annual return. The EIUL policy provided $100,752 annually in retirement, a 64% improvement over the $61,302 from the stock-based portfolio. Over 20 years, this amounted to an additional $788,997.
Dr. Brown appreciated the balance between growth potential and risk management offered by the EIUL policy. The policy allowed him to participate in the equity market's upside while protecting against significant losses. This approach aligned with his aggressive investment strategy while providing a safer and more tax-efficient way to build his retirement savings.
Conclusion
The flexibility, tax advantages and asset protection provided by nonqualified plans make them an essential tool in the financial planning toolkit of any high-income professional seeking to optimize their retirement outcomes.
David Mandell, JD, MBA, is an attorney and co-founder of the wealth management firm OJM Group www.ojmgroup.com, where Jason O’Dell, MS, CWM, is the managing partner and an insurance specialist. They can be reached at 877-656-4362 or mandell@ojmgroup.com.
Mandell and OJM Group partners are pleased to announce the 2024 publication of their newest book, Wealth Strategies for Today’s Physician: A Multi-Media Playbook. The playbook’s innovative format features more than 90 links to videos and podcast episodes to enhance important financial topics for physicians. To receive a free print copy or ebook download, text HEALIO to 844-418-1212, or visit www.ojmbookstore.com and enter code HEALIO at checkout.
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