Income planning helps avoid disasters

Planning for disability when you are young is the best way to protect your interest in your practice.

Kenneth W. Rudzinski

I had just finished playing one of my best rounds of golf last June when an emergency text message hit my cell phone from the spouse of a near and dear physician client of mine. I immediately called back and discovered, from Linda’s tearful explanation, that her husband Brad, age 55 years, had been rushed to the hospital, diagnosed with a life-threatening pulmonary embolism. He was recovering, but his work life would be forever altered, as his condition most likely would impair his income-earning potential from that point on.

Linda’s call was mostly personal, but partly business as well. She, Brad and I had planned for this type of income disaster many years earlier, although fully expecting it would never happen. These things always happen to the other guy, right? But “stuff happens,” whether we like it or not and whether we are prepared or not. Fortunately, Brad and Linda were prepared.

Fast forward to the present. Brad returned to work after about 6 weeks of disability, but he works only part-time (about 20 hours a week), as his strength is no longer conducive to his former 50-plus hour weeks.

However, he has not suffered financially. His personal standard of living has been maintained – including supporting two children in college – and his full-time staff has remained intact.

Further, his two partners have not been burdened with carrying Brad’s salary and bonus while at the same time assuming the professional responsibility of his lost time. Lastly, should Brad’s condition worsen, leading to total disability, his partners know that an orderly exit strategy for Brad stands ready to be implemented, including the funding for the buyout.

If you had been Brad last October, could you (and your spouse and your partners) face an uncertain future with the same degree of confidence and financial certainty? If your answer is “no,” then the following summary of income planning for disasters may be of interest to you.

The bottom rung

If planning for complete disability or incapacity is like steps on a ladder, then the first rung consists of planning for the continuation of your personal income or salary, which is usually guaranteed by good disability insurance.

Many physicians use group long-term disability (LTD) as their sole income protection; indeed, many have no choice because the hospital or business they work in chooses the benefit for them. Others use primarily personal policies purchased on their own or implement personal policies to supplement group LTD where group LTD fails to cover all of their income.

For example, group LTD may use a formula like this: 60% of income up to a maximum of $5,000 per month. A physician making $200,000, therefore, is covered only up to 30% of income ([$5,000 × 12] / $200,000 = 30%). This shortfall is often referred to as “reverse discrimination.”

Further, some of the $200,000 might come from a year-end bonus, which may not be included in the formula if “income” as defined by the LTD contract covers only “salary.” If you manage your own benefits, you must make sure your definition of income in your group LTD covers you properly based on how your income is produced (salary or salary and bonus). If you are part of a group practice or receive your LTD through a hospital or similar entity, check the definition of income to make sure you understand any limitations on coverage amounts. S-corporation profits are not considered earned income for disability insurance purposes and do not count in the formula.

Do not wait until the disability happens; get under the hood of your LTD now to assure yourself that all is well. If it is not, then fix it with the help of your broker or financial planner.

Adding personal coverage

When you add personal coverage as supplemental to group LTD, you may be able to insure upwards of 70% to 80% of your income, depending on whether you pay income tax on the premiums. Briefly, the rule is that you pay tax on either the premiums or the benefits – your choice, so says the Internal Revenue Service. If you pay tax on the premiums, the benefits are tax-free. In that case, the limits on insuring your income are lower, closer to the 70% figure because your after-tax take-home pay is obviously larger when no taxes are due.

The same tax rule holds true with your group LTD. You may want to check with your employer or your human resources staff in a group practice to arrange for LTD premiums paid on your behalf to be taxable to you. That way, like Brad, your benefits will be tax-free when received.

I almost invariably recommend paying tax on the premiums (sole proprietors and S-corporation owners generally have no choice because premiums are almost always treated as after-tax) rather than the benefits. Paying the small tax while you are healthy and making a handsome living beats paying a big tax on benefits you dearly need when your income stops.

With a personal disability policy, you generally want to use the best definition of disability, often referred to as “own occupation” coverage. (Some companies still offer even more refined “specialty” coverage for certain limited medical specialties.) You would then be covered as totally disabled if you cannot work in your occupation as a physician. Income from any other non-occupation source is not counted.

You get full benefits if you satisfy the definition of disability, which usually stipulates “inability to perform the substantial and material duties of your occupation” and that you are under a physician's care.

When you come back to work in your occupation, your policy should have a “residual” disability benefit that pays you, simply put, a percentage of your monthly disability benefit equal to the percentage of your lost earnings. Additionally, less than 20% or 25% disability means you are considered “cured”; more than 75% or 80% disability equals full or total disability.

Brad’s policy had a provision that paid him 50% of his monthly benefit for 6 months, even if his loss of earnings did not support that amount. (His loss of income was less than or equal to 35%.) That is the difference between good quality coverage and “cheap” coverage.

Caveats for group LTDs

Here is a caveat regarding group LTD contracts: Make sure you carefully review the definition of disability in your group LTD. Many carriers advertise their LTDs as being own occupation coverage (occ), but when you drill down into the wording, it may reduce monthly benefits during disability by earnings from work both in and out of your regular occupation. In that case, it is not true “own occ” coverage. In a group LTD hospital setting where you do not control the fringe benefits you receive, it is what it is, but you should know what you have before a disability happens.

Group LTD contracts may have, but usually do not have, a provision for cost-of-living increases. Personal disability insurance, on the other hand, is almost always written to include it (assuming your advisor knows to include it).

Imagine working the rest of your life at 2007 wage levels with no increases. A disability benefit without a cost-of-living adjustment is like ignoring inflation for life and suffering an ever-shrinking standard of living as your fixed benefit buys less and less. Make sure you get a cost-of-living adjustment benefit on your personal policy, and if you control the LTD contract in your group practice ask your broker for a quote on it.

Start young

It is best to start your personal disability coverage when you are young. This way you can take advantage of “graduated” premiums, where costs start out low, then increase each year for a number of years, then level off. This is ideal for young physicians whose income is low when starting out and whose debt level coming out of med school is extraordinarily high. But make sure you purchase a “future insurability option” in your policy, which permits future purchases of disability coverage as your income increases without medical underwriting. (Financial underwriting is required, however, as you need to prove your income to insure that income.) Some policies contain an “automatic increase benefit” that increases coverage automatically by 5% each year for 5 years with no medical of financial questions asked. You may refuse this because your premium will change to reflect the increase. The bottom line is, start early and lock in coverage for your future income potential with automatic future increase options.

The remarks I have made about group LTD through hospitals, large group practices and corporate America also apply to LTD coverage available through various medical association plans. These, in my opinion, are only adequate and should not be your primary coverage unless you are medically uninsurable. If that is the case, then group LTD may constitute your only choice.

Once you purchase individual coverage as Brad did, it cannot be cancelled by the insurance company as long as you pay for it, and it cannot be altered or modified by the insurance carrier, which is why it is sometimes difficult to obtain. Individual coverage underwriting takes into consideration how much group coverage you have, but group does not factor in how much individual coverage you own. Therefore, you should purchase your individual coverage before you obtain group LTD, whether through an association, hospital plan or other source.

Long-term care coverage

Unlike Brad’s condition, some disabilities can be so severe that they might prevent you from performing normal activities of daily living, such as transferring, eating, dressing, etc. These incapacities, as well as cognitive impairments, are normally associated with long-term care (LTC) patients, but they can occur in younger people as the result of accidents or even severe strokes. You may want to look into individual or group long-term care coverage not only to provide continuing income but also to produce benefits to offset possible costs for skilled care, home care or worse.

Many medical plans offer only limited coverage for these type of expenses. Some disability carriers offer extra coverage on top of base benefits to account for disastrous disabilities. If your group practice has more than 10 people, or if you work in a large hospital or a purely commercial business setting, you may have group LTC available to you. My advice is to get it when it is first offered, when you can join with no medical questions. Have your broker or financial planner compare costs and benefits vs. individual coverage obtained through normal underwriting.

LTC insurance is one of the hardest disability coverages to obtain, but it is cheap in a group setting, especially when you are young. Some carriers offer specialty LTC products combined with a single-premium life insurance policy. If you have assets such as certificates of deposit or money market accounts from which you do not need either the principal or interest income, or if you have old life-insurance-only policies with high cash values you are seeking to eliminate (because the need for the death benefit no longer exists), ask your broker or financial planner about these combination life-plus-LTC products as they may enable you to transform single-use money into double- or triple-duty dollars (cash plus life benefits plus LTC benefits).

Business overhead coverage

Brad worked in a small practice of three physicians. In addition to individual disability planning, the practice had obtained “business overhead” coverage on each physician, which reimbursed the practice for Brad’s share of overhead expenses while he was disabled and producing no revenue for the practice.

The business overhead coverage was purchased with a 3-month elimination period because receivables tracked that long will pay for up to 18 months of disability. It covers normal overhead expenses such as staff salaries, rent, utilities, legal and accounting costs. It does not cover owners’ salaries and “expenses” that might enhance owner net worth.

Therefore, while Brad recovers, his share of office expenses is covered, and his partners do not have to work their hours plus Brad’s to produce enough revenue to keep the ship afloat. The premiums for the business overhead coverage are deductible. The policy benefits received under the business overhead policy are taxable; however, the benefits are used to offset tax-deductible overhead costs, so the claim is a “tax wash.”

Business overhead coverage is rather simple and relatively inexpensive as it is generally short-term in nature. The maximum with most carriers is usually 24 months. If you will have ongoing overhead expenses, if you do not want to lose your staff or your office space during a period of disability when your return is likely but your income is suspended, then you should add business overhead coverage to your income disaster lifeline.

Buy-sell disability

What if your disability, unlike Brad’s, kept you from returning to work permanently? For example, what about an ophthalmologist who loses his sight or an osteopathic surgeon who develops rheumatoid arthritis or a dentist, like my own, who develops carpal tunnel syndrome? Individual disability coverage would assure your continuing income, but your return to your practice as you know it could be threatened and possibly eliminated.

But perhaps, like Brad, you own one-third of a successful medical practice that has value, if only based on the receivables and goodwill. Perhaps you had the foresight to draft a buy-sell agreement that covered various exit scenarios. But did it contain what we usually call “the missing page”? That is the set of provisions covering a buyout in the event of total disability of an owner, most importantly defining a “long-term disability” upon which the buyout is triggered.

Even if you had the foresight to include that usually missing page, did you have the same foresight to fund the agreement with buy-sell disability coverage to provide the cash required to buy out a disabled partner? I often see agreements funded by large amounts of life insurance for death contingencies but rarely come across the same agreements funding for the disability possibility, despite statistics that clearly point to a much greater probability of incapacity than death in a group practice of two, three or more.

Buy-sell disability coverage is written for total disability only, usually with a long “trigger” period of 6 or 12 months. (Disabled partners do not want to be bought out too soon because they may recover. Hence the longer elimination period.) Benefits can be paid out over time, as a lump sum or as a combination of the two. The greater the lump-sum payout relative to a monthly payout, the more costly the coverage.

Insurance companies generally will write up to 80% of the value of a practice based on the provisions of the buy-sell agreement and proper documentation provided at the time of application, but the maximum coverage amounts vary by carrier. Only a few carriers actually still sell this coverage.

Even if you do not cover the entire buyout liability, you should consider this type of coverage to underwrite at least the down payment for the buyout. Brad and his partners had purchased coverage equal to about 80% of the buyout amount necessary if Brad actually stopped working due to his disability. That is a handsome start and a significantly reduced ongoing financial obligation that can be covered easily over time.

Space does not permit me to cover this topic in more personal detail. If you send me an e-mail request, I will send you a disability-incapacity questionnaire to use when you initiate your income disaster “fire drill.”

Lastly, would you know your financial condition today if you had lost your ability to work yesterday? If not, do not wait till tomorrow to find out. Disabilities can be devastating in many ways, but they do not have to be economically debilitating. Imagine standing on a spot that had a 25% chance of being struck by lightning. Would you move? Now understand that you have a 25% chance of being disabled for 90 days or longer. Will you move? Will you arrange for a salary continuation fire drill to ascertain what your coverage gaps might be and the appropriate coverages, like those mentioned above, to plug those holes? Brad did, and his story had a happy ending, at least financially. What about you?

For more information:

• Kenneth W. Rudzinski, CFP, CLU, ChFC, CASL, is a registered representative of Lincoln Financial Advisors Corp., a broker/dealer (Member SIPC) and a registered investment advisor in Wilmington, Del. He has been cited in Money magazine and in Who’s Who in Finance & Industry. He can be reached at The America Group, Foulkwood Professional Building, 2036 Foulk Road, Suite 104, Wilmington, DE 19810; 302-529-1320; fax: 302-529-1324; e-mail: kenneth.rudzinski@lfg.com. Lincoln Financial Advisors Corp., or its representatives, do not give tax or legal advice. The information in this article is from sources deemed reliable. This information should not be construed as legal or tax advice. You may want to consult a tax advisor regarding this information as it relates to your personal circumstances. CRN# 200702-2003347